Higher Bond Yields: Are We Making Progress?

A few months ago, I penned an article entitled Let's Just Say It, Print More Money. Some misunderstood me to be touting Keynesian stimulus, which couldn't be further from the truth. Rather, I was looking for an increased money supply to counter deflationary forces by raising the specter of inflation- and not only put a floor on stocks and other assets, but provide a stimulative effect.

For all the talk of Bernanke "printing money", the truth is that most of the money "printed" thus far has been fully sterilized- if you consider Treasuries to be high quality. Given the vast natural resources and manpower of the US and the government's power of taxation, it would be a very aggressive bet to assume default by the US government on its debt instruments. Nothing short of global Armageddon or bio-disaster will keep the US from fulfilling (or at least rolling over) these obligations. Not that we needed Moody's to confirm this by reaffirming a AAA rating.

However, the yield on 10 year Treasuries is ready to eclipse 4%, and an auction of 30 year Treasuries today will shed more light on the situation. But even if yields continue to climb, this is not necessarily a bad thing- yields have been significantly higher during better times. And higher long term rates are not necessarily bad for the market, or the economy- as long as short term rates stay reasonably low.

First, while long term market rates are climbing back towards levels when the economy and markets were both doing better, short term rates are still very low. This adds up to a steep yield curve - good for bank profits. Second, this higher rate will serve to bolster demand for US debt, while at the same time providing impetus for Americans to consider the cost of government overspending. It was said that Ronald Reagan loved large deficits because it changed the nature of the debate in Washington from government spending to government saving. Perhaps higher long term rates will do the same now.

But most importantly, higher bond prices foretell inflationary forces. This is a good thing, because by avoiding the prospect of continued asset value declines, potential investors and buyers can have more confidence that there will be buyers in the future. Accurate price signals in oil and foreign goods can drive purchases of alternatives economically, instead of via artificial central planning. And pressures on semi-fixed cost items, such as union salaries and debt service, can be alleviated.

Meanwhile, excess labor, technology (higher efficiency aircraft, CPV solar, smart grid), and commodities (milk, aluminum, and natural gas for sure) await increasing global demand, ready to mitigate inflation. To the extent that government policies are focused on increasing output instead of subsidizing non-competitiveness, the long term prospects for the US (and global) economy - and stock market- are bright. Higher long term interest rates may help more than they hurt in that regard.

Disclosure: No positions

Comments

[paulsjj:]

Higher rates attract dollars from foreigners which should strengthen the dollar.

Jun 11 08:25 AM

[y1531y:]

Fight Fed that wants to push the rate down, we want up, and we are winning this time. Enjoy it. Feb has no more card to play, we will be winning for years to come till Fed writes off deficit with 50% inflation in 5-10 years.

Jun 11 10:07 AM

[Prudent Man...:]

"Sterilization" is transferring bad bonds for bad currency in circulation and is a Fed scam that a lot of people don't quite get.

Sounds sophisticate so is probable important to academic economists.

Jun 11 10:29 AM

[Mad Hedge F...:]

I'll take some inflation with my TBT please. Just another update on my core short in long dated US Treasury bonds, the TBT, which hit a new high for the year of $60, up 72% from my initial call (www.madhedgefundtrader...). The nine to eleven year note auction went off OK, despite its enormous size. What drove the yield on the ten year to a seven month high of 3.99%, the 30 year to 4.67%, and herded buyers into the TBT was the May US budget deficit of $190 billion, an all time record, despite massive inflows of income tax revenues. There was also word that Russia didn’t want to buy any more US government debt because they hated the dollar. After having spent four decades on the front lines of the cold war, I have to pinch myself when I hear stuff like this. The news sent equities on a 200 point intraday swoon. If higher rates and $70 crude don’t go away, they are going to kill the stock market. Everyone is holding their breath for the 30 Treasury bond auction tomorrow. The time to pay the piper is coming, and his rates are going up.

Jun 11 10:43 AM

[user396040:]

I think that it is possible that one reason treasury yields are going up is that treasuries are no longer viewed as the only risk free debt instrument. As the credit crisis as eased, investors have become more and more comfortable with investment grade corporate bonds and agency bonds. To the degree that these bonds become viewed as essentially default risk free, the supply of default risk free bonds increases enormously and as the supply increases, the price of treasuries decreases. Another way to look at this is to analyze the spread between treasuries and investment grade corporates - that spread has decreased enormously since March.

Jun 11 04:56 PM

[Dirk McCoy:]

Thank you for your comments.

On the question of the linkage between higher rates, dollar value, and inflation, more dollars with the prospect of more supply capacity should translate to lower interest rates as the ability to back up debt with goods and services will support a stronger currency and mitigate inflation. More dollars with the prospect of fixed (or, heaven help us, reduced) supply capacity will create quite the opposite effect.

Beyond the Taylor Rule (which only applies to short term rates), I haven't got very far on quantitative calculations linking all this together (if you discount my fin prof. rule of thumb that rates are usually 4% above inflation). But, qualitatively, as long as our focus remains on improving productivity and spreading economic opportunity to maximize output, I don't believe high inflation, unworkable interest rates, or more radical concerns will be born out.

So, beware the CO2 police, social security/medicaid mob, and welfare state.

Jun 12 04:35 PM