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The
prevailing notion among the main stream media and economists is that interest
rates are rising because of improving economic growth. But like many of the
readily accepted tenets of today's world of popular finance, this too has its
basis in fallacy.
Interest
rates have increased by nearly 40 basis points on the Ten year note since the
first week of March and that is being offered as proof that the economy has
healed and GDP growth is about to accelerate. But in truth, the recent spike
in Treasury bond yields is only the result of a temporary ebbing in the fear
trade that brought about panic selling in Euro denominated debt, which had
previously caused U.S. Treasury prices to soar.
The head of
the European Central Bank, Mario Draghi, just
finished printing over a trillion Euros in an effort to calm the bond market.
This new liquidity predictably found its way into distressed Eurozone debt
and has mollified bond investors; for the moment. Since a Greek exit from the
Euro in no longer perceived an imminent threat, investors have sold their
recent purchases of U.S. Treasuries and piled back into Eurozone sovereign
debt. For example, the yield on the Italian 10 year note took a rollercoaster
ride above 7% at the start of this year, before plunging south of 5% by the
beginning of March.
However, in
contrast to what passes for the economic wisdom of today, an increase in the
rate of sovereign bond yields would be a function of deterioration in their
credit, currency and inflation risks. But it would never be because of an
increase in the prospects for growth. An economy that is experiencing a healthy
growth spurt would experience a reduction in all three of those factors that
would cause bond yields to rise. Strong GDP growth--which results from
increased productivity--serves to improve credit risk, due to a bolstered tax
base, while it also lowers the rate of inflation by increasing the amount of
goods and services available for purchase. Therefore, it also tends to boost
the currency's exchange rate as well.
Economic
growth that is also accompanied by a sound monetary policy tends to lower the
rate of inflation and thus increases the real rate of interest. But it does
this without increasing nominal interest rates. It instead serves to provide
a higher real rate of return on sovereign debt ownership.
This is
precisely what occurred in the U.S. during the early 1980's. After Fed
Chairman Paul Volcker fought and won the battle against inflation, economic
growth exploded while the stock market soared in value. And nominal bond
prices began to fall, not rise. At the start of the 1908's, GDP fell by 0.3%,
the Ten year note was 12% and the rate of inflation was 14%. Therefore, real
interest rates were a negative 2% at the start of that decade. But by 1984
GDP had accelerated to 7.2% in that year. However, the nominal Ten year note
fell to 11% and inflation had plummeted down to 4%. In this classic example
that illustrates clearly how growth isn't inflationary; real interest rates
soared by 9 percentage points to yield a positive 7% return on sovereign
debt! In a healthy economy; stocks, bond prices and the currency should all
rise together as nominal yields fall and real interest rates
rise. The simple truth is that the rate of inflation should fall faster than
the rate nominal yields decrease.
However, what
the Fed, ECB and BOJ are doing now provides a prescription for soaring
nominal interest rates in the not too distant future. These central banks are
violating all three conditions that lead to low and stable interest rates for
the long term. By massively increasing the money supply, they have caused inflation
to rise and reduced the purchasing power of their currencies. And by creating
superfluous money and credit, the central banks have given the cover needed
for their respective governments to run up an overwhelming amount of debt.
The currency, credit and inflation risk of owning those three sovereign debt
markets has soared. Therefore, they have created the perfect conditions for a
collapse of their bond markets.
Central
bankers believe they have more power and influence over the yield curve than
what they indeed posses. The fact is they can only
control interest rates for a relatively short period of time. By not allowing
interest rates to function freely, the Fed, ECB and BOJ are facing the
eventuality of a bond market debacle that will also crush their currencies
and stock markets. Recent history has proven that these central banks will
fight the ensuing run-up in yields with QEs III, IV and V in an effort to
postpone the pain. This failure to acknowledge reality will cause the
eventual collapse to become significantly more acute.
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