Investors have a lot of beliefs about interest rate behavior. One is that an increase in long-term interest rates is a signal of coming economic strength. As it happens, long-term yields invariably fall in the months preceding an economic expansion, and typically remain well behaved as the economy enters a new recovery. Similarly, inflation rates typically decline during the early phase of an economic recovery. There is, however, one remarkably strong tendency in the data, and that is for real short-term interest rates to surge relatively early in an economic expansion.
On this front, the current recovery has been markedly different. Inflation rates have behaved normally, with the recent pickup in producer inflation being typical, but real interest rates have remained negative at the short end of the yield curve. Much of this reflects foreign purchases of U.S. Treasuries, particularly by Japan and China, in attempt to support the value of the U.S. dollar and keep their own currencies from appreciating. With growing pressure on these countries to abandon this policy, the coming upward adjustment in short-term interest rates could be very abrupt.
As I note in Freight Trains and Steep Curves, the U.S. financial system has become disturbingly dependent on continued low short-term yields. Both corporate and mortgage debt are largely tied to low short-term yields. An upward spike would create pressure on both credit risks and the housing market. Look, if Ford bonds can be downgraded to BBB- despite auto sales that have never been higher, the outlook for corporate defaults is hardly sunny.
Moreover, the resilient behavior of Treasury bonds after last summer's slide is also the result of the unusually steep yield curve that encourages “carry” trades (borrow at low short-term yields, invest at high long-term yields). Upward pressure on short-term yields would create significant pressure to unwind these trades. Though my inclination is to believe that higher short-term yields would create enough economic difficulty to keep long-term yields restrained, there could be enough pressure on Treasury bonds from an unwinding of these carry trades to drive long-term yields higher anyway. In any event, numerous economic and financial risks are tied to the level of short-term interest rates. Unfortunately, an increase in short-term interest rates is also baked in the cake.
Let's discuss this for a second.
I do not want to get locked into an incorrect assumption but I think Hussman misses the mark in a couple places.
1H)There is, however, one remarkably strong tendency in the data, and that is for real short-term interest rates to surge relatively early in an economic expansion.
1M)The assumption here is that we are in an EARLY stage of economic expansion. Is that the case? Everyone thinks so. Is it possible we are in the LATTER stages of said expansion, the blowoff top if you would? Look at the GDP. Is 7% going to happen again? Did it really happen at all given hedonics and other nonsense? Is the mortgage refinance bubble ending or beginning? Is there going to be a tailwind from refinancings supporting the economy or a headwind of tapped out consumers? Is there REAL job expansion or is it statistical nonsense that overlooks too many discouraged workers? If there was real expansion would we see it in taxable salaries? One would think so and we did not. Conclusion: we are still losing jobs. Has the macro trend towards outsourcing of jobs ending or is it still in the early stages? Look at medical evaluations and accounting and other services that could be and will be outsourced for the answer. This too provides a visious headwind for expansion to continue. NO JOBS! Can military spending go unabated? What about state budgets? If we lose jobs, cut back services (employment) etc, is that more headwind? Hmmm Now that EVERYONE has dismissed or forgotten about the "double dip" recession (even roach has not mentioned it for 6 months) perhaps now we should be thinking it comes. My conclusion is that this "recovery" is in the latter stages not the early stages.
2H) Inflation rates have behaved normally, with the recent pickup in producer inflation being typical, but real interest rates have remained negative at the short end of the yield curve. Much of this reflects foreign purchases of U.S. Treasuries, particularly by Japan and China, in attempt to support the value of the U.S. dollar and keep their own currencies from appreciating. With growing pressure on these countries to abandon this policy, the coming upward adjustment in short-term interest rates could be very abrupt.
2M) This inflation is due to several factors: Unvelievable printing of $, China sucking up all available commodities, a falling US$. China's expansion is very real. China is likely going to keep expanding whether or not the US does (although at a slower rate than if we do). This is putting pressure on industrial metals, and grains (China had a bad harvest). Raising interest rates is not going to affect China's demand for commodities in the least IMO. China demand could be the biggest reason for the rise in the price of commodities. As for printing, much of this is to support a housing market that has been extremely resiliant. However, signs are that we are down to marginal buyers as evidenced by increasing bankruptcies and more importantly a dramatic increase in adjustable rate loans. FNM has also come out with "skip a pay" mortgages that just might mask some credit problems. Will raising rates in the face of this kill housing? Yes. Will it reduce China's demand for commodities? No. Can we hike interst rates high enough to cure the balance of trade problem? Absolutely 100% guaranteed NO. With China's and India's enormous labor cost advantage, we can not possibly ever hope to raise interst rates high enough to stem the balance of trade issues. As for the unbelievable printing, that can be cured by cutting back consumption. I do not think it takes a rate hike to cause this. Wallmart and other low end retailers are already showing sign of consumer cutbacks. This Christmas season may be a good tell. We will see. If housing is slowing, if spending is falling, if wages are not keeping up with inflation.... I guess this takes us back to #1. Just what state of "recovery" are we in. Early or late? More to the point: just what are we really curing by interest rate hikes if much of the "inflation" is out of our hands and in China's hands and a lot of the rest due to unwarranted military spending?
3H) Though my inclination is to believe that higher short-term yields would create enough economic difficulty to keep long-term yields restrained, there could be enough pressure on Treasury bonds from an unwinding of these carry trades to drive long-term yields higher anyway. In any event, numerous economic and financial risks are tied to the level of short-term interest rates. Unfortunately, an increase in short-term interest rates is also baked in the cake.
3M) This overlooks credit risk in assuming that long term yield are going to be restrained. The example given of Ford was a good one. If F is unable to roll over that debt and defaults, long term interst rates may rise, regardless of what short term rates do. In fact I believe they will rise. One sure fire way to bankrupt marginal companies right now is in fact to hike short term rates. Too many companies are too dependent on short term borrowing right now. Hiking interet rates is going to cause so much stress that it could cause all kinds of havoc in junk bonds, marginal companies and as a result feed over into the stock markets. All the more reason it will not be done unless absolutely forced by some external event. Now a 1/4 hike or two 1/4 hikes in succession would probably be all it wouldtake to throw this marginal economy back in full blown recession and the end result of that will be cutting rates NOT hiking them. If we see those hikes (a recession has not started by the end of next year, and we hike) we are guaranteed a recession in 2005 and we will probably "pull a Japan" cutting interst rates down to .5 to restimulate the economy. Nope. Every which way you turn, we have an enormous debt overhang, try as hard as Greenspan has to inflate our way out of it, we have had little to show for 13 rate cuts other than more lost jobs, a housing refinance bubble, and tapped out consumers. Thus we keep coming full circle. No more than two 1/4 rate hikes followed by more rate cuts if we do them. We may get those rate hikes, but they are extremely unlikely to be as much as eurodollar futures imply. Nor will we get as many as anyone thinks, and in fact we might not see any at all. Greenspan will be very relucatnt to hike rates in an election year (under pressure from Bush) and unless and untill there is real strength in jobs (which given the headwinds of China, outsourcing, and overcapacity is very unlikely), there is going to be severe resistance to hiking. Finally, Greenspan will not want to be the one to be blamed for killing this recovery, and may be hoping to retire in June and leave the dirty work to someone else next year. By then we can easily be back in recession (or about to head into one). If they hike, we will be in one and the hikes will not be many.
Mish |
