Rising Long-Term Interest Rates Go Hand in Hand with the Expanding Economy

We thought we’d look further into rising interest rates. As we pointed out, bond yields have been rising at their fastest rate in 25 years. The yield on the 10-year U.S. Treasury bond, is 60 percent above its December low.

Rising long-term interest rates go hand in hand with an expanding economy as demand for credit typically pushes yields higher. A number of consumer lending rates key off of the 10-year bond, which is why 30-year fixed mortgage rates have climbed back above 5 percent.

What’s different this time around is that rates have made a big move even as the economy is only showing just a few “green shoots” of improvement—far too few to pronounce a real turn in the economy. If the government is truly going to get the economy on an upward track again it will need to keep mortgage rates in check so as not to derail a recovery in the battered housing sector.

To do this, the Federal Reserve is resorting to so-called “quantitative easing,” effectively printing money to pay for the bonds. The Fed has already stated its intention to buy up to $300 billion in Treasury bonds, $200 billion in debt from government-sponsored enterprises (GSEs) and up to $1.25 trillion of mortgage-backed securities guaranteed by the GSEs and federal agencies this year. But if rates keep rising, the central bank will have to keep buying Treasurys and agency paper beyond those targets to artificially hold rates down.

While quantitative easing should help to stimulate the economy, and relieve troubled banks in the process, it will bring with it an unintended consequence: raging inflation. Since last September we’ve seen Federal Reserve Bank credit soar from around $890 million to more than $2 trillion. The additional bond purchases will only add to that staggering sum.

Putting that money into the system is one thing, wringing it out of the system later is quite another. In the tradeoff between fostering growth and fighting inflation, government officials and central bankers will opt for higher growth every time.

Already we’re seeing signs the bond market is signaling that inflation will return. Take a look at the graph below. It shows the performance disparity between a basket of longer dated Treasury bonds and Treasury Inflation Protected Securities, which are bonds that adjust the income stream with inflation. As you can see, garden variety bonds have lost considerable ground this year while the inflation protected bonds have advanced.

Owning inflation protected securities through an ETF, such as the Treasury Inflation Protected Securities ETF (TIP) or a mutual fund such as the Vanguard Inflation Protected Securities Fund (VIPSX) is a good idea. But all investors should also hold a fair portion of their assets in the ultimate inflation hedge: gold.

Gold is the forgotten asset class. The metal steadily lost value during the Great Moderation, the extended period of low variability of economic output and declining inflation that ensued after then Fed Chairman Paul Volcker raised interest rates to never-before-seen levels. And while gold has been the top performer during this decade it’s still decidedly undervalued. Adjusting for inflation, the yellow metal would have to rise above $2,500 just to match its 1980 monthly average peak. We think it will climb far above that mark in the coming years.

Our portfolios are peppered with gold via the SPDR Gold Shares (GLD) and gold stocks by way of the Market Vectors Gold Miners ETF (GDX) and a number of individual names ranging from blue chips, to mid-tier miners, to smaller, more aggressive players. Spread your risk by purchasing a number of these shares. Then sit back and wait, you’ll be well rewarded for your patience and foresight.

Comments

[socrateazz:]

A thought I would add is that. Your assumption is interest is needed for expansion of the economy. Much of today's need for interest is for covering expenses. When that is the case, You can expect long term interest rates to also be related to a dying economy! A balanced economy would allow greater lending and thus more trust by the lenders causing lower interest rates. A strong economy would cause a shortage of monies to lend thus causing higher interest rates. An inheritantly weak economy would demand money to keep businesses going. thus fewer lenders would be willing to loan because of fear of default. Where are we now? What is reality? Do not always assume any accepted belief is correct!

May 14 08:23 AM

[Carlos Lam:]

You are correct that rising interest rates go hand-in-hand with an expanding economy. You are also correct that they go hand-in-hand with inflationary expectations. The question is, which of these two factors is contributing more to the recent rise in interest rates? My bet is on the inflationary expectations theory.

The idea that the economy will soon resume its growth course (i.e. green shoots theory) totally ignores a few inconvenient facts. First, Americans continue to lose jobs at a fast pace, as witnessed by the 600K+ figure released today. Second, household debt is at about 100% of GDP; Americans simply can't buy "stuff" when they have to pay off debt. Third, home values continue to plunge, as noted by data from Case-Schiller, and foreclosures have recently reached an all-time high. Finally, the Federal Reserve and Pres. Obama's administration continue to increase the "regime uncertainty" in the economy: industries are reluctant to expand lest they be met with a bevy of tax increases, new regulations (i.e. global warming...errr...climate change), and bailouts to competitors (i.e. community banks vis-a-vis big banks, Toyota & Honda vis-a-vis GM).

On the other hand, the inflationary expectations theory seems well-founded. The amount of liquidity poured into the financial system by the Federal Reserve is unprecedented. Simply put, Bernanke & Co. have "printed" tankers of new dollars; this means that the value of every individual dollar is diluted since it's no longer as scarce as it once was. Secondly--and it's related to the first point--fiscal stimulus (nearly $1 trillion worth) is immense, and the "money" to finance it will come to one degree or another from the Fed's printing press.

May 14 10:37 AM

[Did U Think...:]

I think a lot of PhD types would like to sell us on the idea that rising inflation=rising economy. Sorry, rising inflation = rising theft of private property via the Jedi mind trick of an increased money supply. If I buy for and gas for $20 today and the same exact food and gas for $25 next year, did the economy rise or was it just the rise of the eCONomists and their CON jobs? Wages will not keep up with the increase in the money supply so the consumer loses out again. The government and its colluding banking elite treat private property as their own little piggy bank to be raided each time one of their leveraged gambling schemes, such as Greenspan's "great moderation" goes south.

The great moderation was nothing but a great lie. Anyone with a PhD in economics who is associated with academia or with the government is suspect as a being part of this immoral conspiracy against the American people.

May 14 10:51 AM

[deuxsous:]

rant rant rant.... Dr Leeb is correct...rising rates accompany inflation which is what the whole new government is working on creating by choice. But rising rates also accompany rising GDP for a long long time until they are "too high". Accept it and invest accordingly.

May 14 11:07 AM

[reluctantQuant:]

Hmmm... no examination of TIPs implied inflation breakevens? Not rocket science, albeit imperfect. Better if you use a pair of constant maturity indices. I'll use 7-year, since 7 is such a lucky number (especially in, say.. October 2007). Note to non-bond-geeks: If I have a seven year nominal treasury and a seven year inflation-protected treasury, the simple yield difference is a simple indicator of the inflation premium paid by the nominal bond above the inflation protected security. Note to true bond-geeks: yeah, there are devils in the details, so just take it with a basis-point of salt.

so here are the month end values for the last year...
06/30/2008 2.44
07/31/2008 2.16
08/29/2008 1.97
09/30/2008 1.23
10/31/2008 -0.61
11/28/2008 -1.43
12/31/2008 -0.09
01/30/2009 0.73
02/27/2009 1.00
03/31/2009 1.14
04/30/2009 1.29

Wadda we see? Well, yes, inflation expectations are indeed rising, but the first half of 2008 averaged about 2.25. And interestingly enough, it's never broken 2.90 on a weekly chart. Again, this is 7 year forward expectations. I'd say that BondLand is indeed out of "disinflation mode" - as we would expect. When this gets north of 2.50, then the inflation concern gets interesting. The bond market is a better forecaster than most, and it's not yet buying the hyperinflation trade. Supply and demand dislocations between FRB/UST action, Dealer balance sheet stress and unwinding the flight to quality trade are much larger factors in today's market posture. Those factors MUST be included in any short term rate move interpretations. This inflation indicator is based on very very large capital flows, folks. Something to watch. Not screaming yet. Stay tuned.


--rq

May 14 03:36 PM

[JBP:]

On April 16, U.S. President Obama wrote a letter to congressional leadership seeking support for the U.S. government to loan the International Monetary Fund $100 billion. This is part of a plan for the IMF to expand its New Arrangements to Borrow (NAB) program from $50 billion to $500 billion.

President Obama is portraying this loan as an investment rather than an expenditure when he stated in the letter, "Such participation effectively represents an exchange of assets rather than a budgetary expenditure, and it will not result in budgetary outlays or any increase in the deficit. That is because when the United States transfers dollars to the IMF under the NAB, the United States receives in exchange another monetary asset in the form of a liquid, interest-bearing claim on the IMF, which is backed by the IMF's strong financial position, including its significant holdings of gold."

The supposed purpose of the increase in the NAB is to help combat worldwide financial crises. The United States would provide 20 percent of the assets for this purpose. China has already committed to lend $40 billion.

There is a small chance that the difficult-to-understand language in President Obama's letter could be taken at face value.

But, I don't really think so. There are a lot of implications to this proposed loan beyond what appears on the surface.

There is growing pressure on the IMF to actually sell some or all of its supposed gold holdings. If this pressure becomes strong enough that action is taken, there are a number of potential problems that could be exposed:



" The IMF does not physically hold the gold. It has been pledged by member nations who, in theory, have delivered the gold to one of four countries designated as depositories. The United States and United Kingdom are two of the designated depositories. It is entirely possible that one or more nations might, if called to turn over their gold, default on delivering their gold commitment.

" Although the IMF tries to pretend that it audits the gold holdings, it then immediately contradicts itself by reporting that holdings in depositories are not audited by the IMF.

" There is significant suspicion that some of the gold pledged to the IMF has been leased. If the IMF were to try to sell it, that could force the recall of some gold leases.

" It is also possible that some of the gold pledged to the IMF has conflicting ownership claims.

" The IMF only theoretically has 3,217 tons of gold, which at $920 gold spot is worth only $95 billion. Where would be the collateral for the other $400 billion of planned borrowings?



I'm not saying that there is any outright proof of the existence of any of these above problems. However, when the Gold Anti-Trust Action Committee made multiple attempts to clarify the nature of IMF gold holdings. The IMF's answers simply did not respond to the questions asked by GATA. If there were no problems with any of these issues, I would have expected the IMF to make straight statements to that effect.

Another implication is that the U.S. government is holding the gold it has pledged to the IMF as part of the collateral for the "loan." At the most extreme, this may be a sneaky way for the U.S. government to accomplish two goals - increasing its gold position by reducing its gold liability to the IMF and increasing its physical reserves, and to latch on to IMF gold rather than let China purchase all of it. Under these scenarios, the "loan" would never be repaid in U.S. dollars.

If the U.S. government is really trying to find a way to acquire more gold, and trying to do so in a way that the public does not know about, the implication is that, at today's levels, the U.S. dollar is significantly overvalued. Also implied is that gold is underpriced today.

The known fact is that President Obama has asked congressional leaders to pass legislation to enable this $100 billion loan. The rest is speculation as to what is really occurring, when placed in the context of all the other global financial calamities.

May 14 03:51 PM