Will Interest Rates Sky Rocket as Inflationary Pressures Build?

By: Money_Morning

Martin Hutchinson writes: U.S. Treasury bond yields are going higher - much higher. And that’s even before we factor in the likely effects of rising inflation, which we haven’t seen yet, but can certainly anticipate.

Throughout the news media, commentators are noticing new “green shoots” - early signs of a recovery in the U.S. economy, or at least preliminary evidence that this nasty recession may be bottoming out. This is probably still a little premature, although the evidence that the recession’s downward slope has eased is overwhelming enough to have fueled a two-month rally in stock prices.

That stock-market rally is probably premature, too; in the near term, at the very least, stock prices have clearly outpaced economic reality. Indeed, investors should bear in mind one very important caveat: This time around, the recession’s bottoming out will likely lead to much higher long-term interest rates. And those higher rates will manifest themselves in the form of higher U.S. Treasury bond yields.

Let’s take a closer look to see why this is so.

An Overview of a Rebound

Normally, at the nadir of a deep recession, interest rates do not move much. Funding needs for capital investment are low, housing finance is in the doldrums, inventory-finance needs are low and consumer savings rates are relatively high. As long as the government deficit is under control, there’s no need for rates to move up until consumer and business loan demand starts to grow robustly.

Moreover, any tendency for rates to move up is self-correcting, since it produces a moderation of loan growth. Indeed, if the government-financing deficit is kept under control, there is a tendency for long-term interest rates to move down, accelerating the recovery.

Naturally, inflationary expectations can distort this picture. If, as in 1974, inflation isn’t a problem, you can get the extraordinary effect of the U.S. federal government switching from handing out “Whip Inflation Now” buttons to frantic fiscal stimulus within the space of six weeks. On the other hand, if inflationary expectations are very high, as they were back in 1982, real interest rates may reach extraordinarily high levels - even while the economy is in recession.

The Catalysts for Higher Yields

This time around, however, we are not in a normal recession.

Monetary policy has been extremely stimulative for the last six months, with broad money growth running at more than 15%, and real interest rates substantially negative. The justification for this - that the United States was in danger of substantial deflation - was proved to be erroneous by last week’s report on first-quarter gross domestic product (GDP). In that report, the deflator - the rate at which domestically produced goods increase in price - was a surprisingly high 2.9%, indicating that inflation has by no means gone away.

In addition, the U.S. Federal Reserve is buying securities in the markets and financing others to do the same; its purchases of U.S. Treasury bonds, in particular, are nothing more than a pure monetization of the U.S. federal deficit, which can only lead directly to higher inflation.

The German Weimar Republic, during the years leading the 1 trillion percent inflation in 1923, monetized 50% of government expenditure. The Fed, through its program of buying $300 billion of T-bonds in six months, is currently monetizing about 15% of federal expenditures, not as high as Weimar, but enough to nonetheless bring about a severe danger of inflation.

On the fiscal side, the federal government is going to borrow about $2.5 trillion this year - money that will enable it to finance its $1.8 trillion budget deficit, while also fueling investments in banking, housing finance, automobile production, etc. (which don’t count toward the deficit because there’s some chance that taxpayers will get some of their money back).

Overall, we’re talking about aggregate borrowing that equates to about 20% of GDP, a record-breaking number that can be expected to put a huge strain on the world bond markets.

With inventories collapsing (they were down by $103 trillion in the first quarter), and releasing cash to businesses, some of the strain of this financing has so far been hidden.  In addition, April is the U.S. Treasury’s best cash flow month, usually showing a substantial surplus, as businesses and individuals make their final 2008 tax payments.

However, we are now in May. And as the economy begins to bottom out, the inventory decline of the first quarter is showing signs of halting, or even reversing. That’s why people are so optimistic about “green shoots” of recovery.

Hence, the Fed’s borrowing numbers over the next few months are going to be well in excess of previous records (other than at the height of World War II).

That is bound to put upward pressure on medium- and long-term Treasury bond rates, as well as on inflation. Already, the People’s Bank of China - Mainland China’s central bank and one of the world’s major buyers of T-bonds and federal agency bonds over the last few years - has expressed deep unease at the trends in the dollar and in federal financing.

You can already see the results of the pressure on Treasury financing. The 10-year Treasury bond yield, which bottomed out at 2.07% in December, last week broke decisively above 3% for the first times since the financial crisis started last September, and is currently trading at around 3.17%.

The fact that the market isn’t yet worried about this is evidenced by the continued strength in stocks. For market bulls, the growing signs in the last two months that we are close to the bottom of the recession must truly mean that “Happy Days are Here Again.”

But with the U.S. Treasury singing “Brother, Can You Spare a Dime” - or rather $2.5 trillion - Treasury bond yields are going much, much higher. And that’s without even considering the likely effects of rising inflation.

How much higher will Treasury bond yields move? In the 1990s, for example, 10-year Treasury bond yields averaged 6.67%. That’s a period when inflation averaged 2.9% - ironically, the same as the deflator in the first quarter GDP announced last week - and the federal budget deficit averaged a mere 2.3% of GDP.

So it seems reasonable to me that 10-year Treasury bond yields could easily rise to that level again. And if my prediction proves correct, we’ll see that there’s going to have to be one hell of an adjustment by the U.S. housing market, the stock market and the U.S. economy in general.

Money Morning/The Money Map Report

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