On Rates, Part II: Will They Stay This Low?

Submitted by Rich Toscano on July 16, 2005 - 9:52pm
In the first bond rate article, I discussed several factors that have helped to keep long-term yields low. The piece concluded thusly:
It's quite the virtuous cycle, for now, and bond yields will continue to remain low as long as all these factors remain in place. But how long will they remain in place?

This article discusses three scenarios that could throw a wrench into the low-rate works. One of the three is unlikely to take place; the other two are almost inevitable.

1. A Reduction in Foreign US Dollar Holdings

In the first article, I described how the export-centric Asian economies are keeping their currencies low against the dollar by recycling US trade dollars into dollar-denominated assets such US bonds. Such an arrangement appears on the surface to be good for everyone—Americans benefit from cheap goods and low borrowing rates, while the Asian governments keep their people employed and build up their manufacturing infrastructures. The problem is that the dollar-recycling model is not sustainable.

It must be understood that the foreign central banks (FCBs), by purposely keeping their currencies weak, are undercutting their own citizens' purchasing power. They are in effect sacrificing domestic consumption in order to subsidize their export businesses, and at some point this system will cease to be useful. Perhaps some of these economies will be on firm enough footing in the future that the FCBs find it politically expeditious to ramp back their currency-driven export subsidies. More likely, the perceived benefit to the export sector may soon be outweighed by the inflationary effect of weakening one's own currency, which drives up costs of oil and other imported necessities.

The place to look is China. China actively intervenes in the currency markets to keep its yuan trading in a very narrow band against the dollar. It is widely felt that the rest of Asia is following China's currency-intervention lead as a means to stay competitive, and that a strengthening of the Chinese yuan would be followed by that of other Asian currencies. It is also well known that China walks a very fine line between keeping their export industries strong and debasing their currency to the point where inflation becomes a serious problem. In a real sense, our long-term interest rates are more tied to the Chinese economy than our own.

However, we may not even have to wait for Chinese inflation to heat up if our own politicians get their way. Numerous politicians at the federal level have taken to blaming all our problems on the Chinese currency peg, and a couple of senators have gone so far as to threaten a bill to impose huge tariffs on Chinese goods if China doesn't stop weakening its currency. In light of the increasing protectionist chest-beating it is expected that China will revalue sooner than later; and when it does that could very well start to push rates upwards.

Beyond the protectionism and beyond the inflationary risks lies a deeper problem: these FCBs are holding enormous amounts of an asset that is almost guaranteed to decline in value—and yet they keep buying more. I am speaking, of course, of the US dollar itself. Multiple years of currency intervention by Asian central banks has rendered the US dollar significantly overvalued against Asian currencies. Keeping the dollar strong, after all, was the entire point.

But now the FCBs are in a bit of a tricky situation. They are all holding massive amounts of dollar-denominated assets (to give an idea of the scale involved, Japan and China together hold $1.6 trillion in US dollar assets). Should the dollar decline significantly in value, these countries would take huge losses on their dollar holdings. But the only way to keep the dollar aloft is to keep up their own currency-weakening efforts, which can only be accomplished by... buying more dollar-denominated assets, and attaining an even bigger collection of dollars to eventually lose money on!

There's little doubt that each of these countries would love to be rid of its respective dollar holdings. But due to the massive amount of dollars involved, if any country were to sell off a big chunk of dollar holdings, the dollar's value could decline in a big way. And the resulting decline in the dollars value would A) hurt that country's export sector and B) decrease the value of its remaining dollar holdings.

It's quite the Catch-22, and everyone seems sort of trapped for now. But don't mistake that for stability. If a single central bank were to panic and start selling dollars, a chain reaction could ensue wherein other FCBs and private foreign investors headed for the exits and started dumping their dollar holdings. The result would include a massive bond selloff and an accompanying steep rise in interest rates.

The dollar's 2005 rebound has stemmed concern of a dollar panic for now. But when the dollar starts back down again (and it will; our debt levels and rate of new debt accrual make a dollar decline inevitable) a foreign flight out of the dollar and an ensuing rate spike will become a real concern again.

2. An Aggressive Fed

Back on the home front, long rates have been able to stay low in part because the Federal Reserve has promised "measured" rates of increase while maintaining that inflation pressures are "contained." In other words, the Fed has indicated that not a whole lot of tightening will take place, and that there will be few surprises. Given that long-term rates area based on expectations of future short-term rates, the Fed's words have emboldened the holders of long-term bonds to accept fairly low rates.

This could all change if the Fed actually did surprise the financial markets with either the speed or magnitude of its rate increases. That said, such an outcome is unlikely. A steep rise in long-term rates would cause the serious trouble to the U.S. economy and financial markets—an outcome the Fed would prefer to avoid at all costs. Furthermore, the Fed remains fairly complacent about the mania in certain housing markets (skyrocketing real estate values are apparently considered not "inflation" but "a bull market"). So the likelihood of the Fed getting too aggressive seems fairly low. However, it's worth mentioning, as the Fed has tightened too quickly in the past. Additionally, the Fed will get a new chairperson next year and it's possible, though unlikely, that the new person will be much more aggressive than Greenspan.

3. Increased Inflation Expectations

A key element in allowing long rates to remain so low lately has been the expectation that consumer price inflation will remain low. An increase in inflation expectations would certainly put upward pressure on rates—but what could put upward pressure on inflation expectations? Off the top of my head I can think of four things.

First: the CPI (Consumer Price Index, a government measure of inflation) increases significantly. This would clearly raise inflation expectations. However, it is unlikely to happen. The CPI does not include home sale values, but rather includes rents, which due to the housing bubble are rising quite modeslty. And the widely-quoted "core" CPI rate excludes food and energy. Adding in various statistical jiggering and the continued downward price pressure coming from the Asian exporters, the CPI is unlikely to surprise much on the upside any time soon. Unless...

Second: the Asian central banks let their currencies appreciate against the dollar. This would immediately cause an increase in the prices Americans pay for all those Asian imports, and would doubtless bump up the CPI. And the increase in consumption within the Asian economies (an inevitable result of their stronger currencies) would further increase the competition for, and therefore the price of, oil and other goods traded on the international markets.

Third: the Chinese don't revalue their currency, and our misguided congresspeople are able to put tariffs in place. The 27.5% tariff on Chinese imports would certainly increase consumer prices in the US. (Whether that increase would make its way into the CPI is another matter).

Fourth: the Fed stops raising rates (and starts lowering them). The fact that the Fed is tightening monetary conditions and ostensibly keeping inflation in check has doubtless helped to keep the bond market complacent about inflation. When the Fed stops tightening, some of that complacency may disappear. When the Fed starts lowering rates, inflation expectations will almost certainly rise, and rates may rise along with them. As I've discussed, I believe that the Fed is fairly close to completing its tightening cycle, so inflation expectations could increase within a couple months. When the Fed starts lowering is unclear for now, but the combination of a potentially slowing economy and financial market nervousness about a new Fed chair could induce the Fed to start cutting as early as the beginning of 2006.

What Now?

Despite all the cards stacked against the low-rate regime, everything appears to be doing fine for now. And it's possible that it will keep doing well, and that rates remain low for years to come. That is to say, if the Asian economies slow down, and there is no dollar selloff, and our congresspeople back off their protectionist rhetoric, and oil prices ease, and the CPI stays low, and the Fed engineers the perfect soft landing, then rates can probably remain low. Otherwise? I'm not so sure.

It's hard to believe that all those pieces will fall into place. It is inevitable that Asian central banks and private investors eventually divest themselves of some dollar holdings and that inflation rates increase accordingly. But when that happens, and how fast, is unknowable for now. Let's just keep alert, and remember that in the bond market, all is not as serene as it seems.

(category: )