In economics, the moments when you can make really high conviction calls are so rare that you have to relish them. Such a moment is currently in the making with the forecast that US long-term interest rates will continue to trend higher. Moreover, since the US interest rates are the most important factor to explain what is going on in global bond markets, we can safely extend the call: global long-term interest rates will continue to trend higher.
No, it is not inflation, which will be the main driver of interest rates going higher. If you are Greek, Portuguese or Irish, then you already experienced a crash on your bond market despite rather low inflation rates. The cause being a massive deterioration of the quality of sovereign credit, with Greek government bonds already considered “junk,” and the other two countries barely faring better. However, Greece, Portugal and Ireland are, in my view, the canaries in the coalmine.
Japan’s government debt-to-GDP ratio at over 220% is almost twice as large as the Greek metric. Last week Standard & Poor's issued a negative outlook on the rating of US government debt, something the UK already experienced a couple of months ago. Even virtuous and supposedly frugal Germany’s 75% government debt-to-GDP ratio doesn’t look so sound anymore once you take the still shaky German banks, as well as the German lender-of-last-resort role for the European periphery into account.
Beside the credit quality deterioration, there is something else which should push US long-term interest rates higher and again no, it is not necessarily inflation. Central bankers are still explaining to the public that they have inflation under control, and that in the case of surging inflation expectations they would just increase interest rates.
A good economist friend of mine attended a dinner in 2008 at which Alan Greenspan was present. The former “maestro” was asked if he didn’t think that what the Fed was doing would lead to substantially higher inflation. Greenspan said that the Fed’s easy money did pose some inflationary potential down the road. But he also said: “If there is one thing central bankers know, it is how to deal with inflation. We will first try a Fed fund rate of 5%. If that does not work, we will try 10%. And if that does not work, we will try 15%. But we know what to do.”
The first doubt about such a statement is whether central bankers will have the backbones solid enough to implement such a highly unpopular policy. Not everyone is Paul Volcker, the Fed chairman who enforced such measures in the early 1980s, but we leave this as a side-remark. Lifting Fed fund rates goes hand-in-hand with reducing the amount of money in the economy. Money, measured by the monetary base, has swollen from 800 billion US dollars by mid-2008 to somewhere north of 2,600 billion US dollars by mid-2011.
Even though the Federal Reserve claims that it can fine-tune the amount of money by lifting the interest rates it pays on the reserves the banks must hold at the central bank, I doubt that a more restrictive monetary policy can be achieved without reducing at least some of this ballooning monetary base. Reducing it would mean selling a portion of the trillion US dollar treasuries that the Fed has bought over the last three years. Selling government bonds in turn means pressure for lower bond prices and therefore higher interest rates on long-term government bonds.
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