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  • Long-Term Interest Rates and Inflation Will Fall on the Medium Run. 0 comments
    Mar 27, 2011 10:05 AM

    It is important to understand that the determinant of Long-Term interest rate is the result of the balance between Investments and the profit that they yield by the demand for their products. And that means that deflation rather than inflation is on its way.

    Underlying Long-Term Yields:

    Because the poorer has a higher propensity to consume than the richer who saves a higher share of his marginal income (which normally go into productive assets and then increase the production.) it is clear that as time goes by and the gap between the rich and the poor increases the balance between the offer of product and the demand for that product tilts in favor of the offer.


    If a very poor receives an incremental $1 he will spend all of it (his marginal propensity to consume is 1) while if the very rich receives an incremental $1 he will save all of it (his marginal propensity to save is 1) which will translate, in a normal economy in an increase of $1 in investment. So all the revenues are not equal, what falls in the pocket of the poorer is used in a different way than what falls in the pocket of the richer.


    Because demand in units is necessarly equal to offer in units that shift result in a lower price of these goods and services.

    One striking example is that one of the company that has the highest pricing power, Apple, never increase the price of the next generation of their produce despite their increased technological content.

    Some will argue that the increase of productivity results in an increase in profit. In fact that increase in productivity means even lower incomes for the weakest which means an even sharper fall of the ratio consumption/production and the profits.
    So the higher productivity feeds back into a lower ratio demand/offer of goods and services. It results that inflation whatever its cause, is met by a lower saving rate and that can be only short-lived. We will explore the sum result of higher raw material prices, which is now a crucial factor, later in this text.
    Eventually the profit derived by an unit of production will fall although there are gains from productivity. This is even faster when there is a high rate of unemployment and the bargaining power of workers diminishes.
    So the profit that are derived from a unit of productive asset goes down. That fall results in the marginal return of productive assets. (Which is different from the return of individual corporations which might make profit much higher than that marginal, minimal return of a going concern.) That lower rate of profit does not mean that the absolute value of profit is going down but that the ratio of the profit of the company divided by its market value goes down which is reflected in a higher PER.
    So if an increase of productivity that is the natural result of competition and profit seeking is good for the corporation from a micro point of view it is bad for the returns on Investments.
    That fall is well illustrated by the long-term fall of Long-Term Yield of 10 Years US Treasury Bonds since 1981 (The case of the increasing yields of 70's comes from a special short-term effect that can't be repeated: abandon of the Gold Standard which resulted in a temporary change in incomes distribution.)

    Long Period Chart of the Yield of the 30 Years US Treasury Bonds.


    That does not mean in anyway that the aggregate demand for Good and Services diminishes it means that the balance between demand and production and the share of revenues of the poorer diminishes which is obvious to everyone of us.

    It doesn't mean either that the revenue of the poorer diminishes it means only that his share of the global revenues goes down compared the revenues of the rich.

    That increase of revenues of the rich can be seen either in their dividend distributed but more importantly in the retained profits of corporations they own which are all funneled one way or another in a ever growing stock of productive assets.

    Raw Material Inflation:

    The special case of raw materials deserves a special attention. Many have accused the Fed of missing the point when they focus on the core inflation numbers rather than headline inflation. This is one of the rare cases where I will defend the Fed's point of view.

    Whith low bargaining power the increase in prices (headline inflation) does not bring higher wages. That means that an increase in raw material prices doesn't imply an increase in Aggregate Demand it simply implies that the demand is shifted away from processed products to raw materials. All of the increase of raw materials gets in the hands of the producer and that does not imply higher costs and wages. The increase of the prices of raw materials is met by a matching decrease of the price of processed goods and services those that do generate employement and wages. It means a even higher revenue gap. So the increase of prices of raw materials in the long run means an even faster drop of long-term yields. This is why it is better to focus on the core inflation numbers than on the headline inflation as they reflect two different economic phenomenon: the increase of the core rate means a higher demand for processed goods in which most of the cost is distributed as wages while the increase of raw materials and in anyway the increase of headline inflation will always be a temporary phenomenon.

    Effect on GDP:

    GDP = C + T - I + E;

    Where C is the Demand of Goods and Services, T is the Investments, I is imports and E is exports.

    First we see that the Imports of raw material impacts adversly the GDP.

    Second we see that an increase of Exports of processed Goods will affect positively the GDP. So some of the decrease of the demand for the production of the stock of investment can be met by Exports which is now mostly constituted by those in direction of emerging countries (the BRICS).

    Third an increase of GDP of a Country which is caused by a lower Trade Deficit and lower Consumption does nothing to increase the well being of its citizens.

    However that is adversly affected by two factors:

    First the fact that most of the production of those emerging countries is generated by their exports and a decrease in their exports will necessarly affect the growth of these countries in a disproportionate way.

    Second the income gap in these countries is much higher than it is in developed county so the decrease of prices in these countries and the local demand will be amplified by the decrease of their exports in a much greater way than it is for their developped counterparts.

    Exports flow naturally from Countries whith the highest income disparity toward the Countries of lower income disparities.

    Should the level of Export from the BRICs start to be only stable the effect on prices and Demand in the BRICS would be catastrophic and create a Global Crisis. So a positive trade balance, and that runs against common sense, would be a catastrophe for the US.

    Contrary to the common belief the demand from highly populated emerging countries can't match the decrease of Demand for processed Goods and Services in developped Countries.

    The Case of the 2009-2011 Period:

    When we watch at that relatively short period we see a seemingly different story which lead some people believe that the secular downtrend in Long-Term Yields and Inflation has ended. We are going to show why it is not true and taht our precedent analysis still holds.

    Chart of the Yield of the 30 Years US Treasury Bonds since the Great Recession.

    If we look at the Chart from a longer-term perspective we see a different story:

     Long Period Chart of the Yield of the 30 Years US Treasury Bonds.

    Long-Term Chart of Inflation.

    The Great Depression has created an temporary breakdown of investments, which have resulted in a breakdown of Consumption. That breakdown has resulted in a higher unemployement rate and hence in a higher disparity of Revenues. However short-run fall of Long Term Interest Rates didn't create a commensurate increase of Income Disparity. So as investments recovered the Underlying Long-Term Yields although staying lower than what it was before the Great Depression still was not as low as the Long Term Yields Observed during the most acute part of the Great Depression. However it is lower than its previous level.
    We see that the growth of Long-Term Yields from March 9th 2009 is not sustainable as Income Disparity will necessarily continue to grow..
    We are now going to see why Quantitative Easing did cause some sort of overshooting and why it will be only temporary.

    Quantitative Easing:

    There are two effects of the combined Quantitative Easing and Fiscal Policy. The first one is a lower than normal Long-Term Interest Rates (QE), as expected combined with an higher than normal demand (Fiscal Policy) which has created a higher demand for Investment and to a lower extent an increase in Consumption.

    The second effect is a return to the underlying interest rate which has caused a disproportionate increase of Investments as Corporation borrowed and spent in order to run after the increase in Long-Term Yields. That behaviour of the crowed was not matched by an increase of the Income Disparity so the Stock of Investments have overshooted the amount that is coherant with that Income Disparity. So now the stock of Investment is most probably too high for comfort.

    Given the trend before the Great Depression its is most probable that the underlying level of Long-Term Yield is below 4.60%, which they have only briefly surpassed.

    What Should we Expect Now:

    First a decrease of inflation whatever the price level of raw materials which, and that is most probable, will continue to increase (confer my article The Commodites Conundrum: The Hidden Parameter in Interest Rates.)
    The first thing you want to watch and it is definitely the most important parameter is Long-Term Yields. If the Yield on 30 Years US Treasury Bonds gets below 4.30% we are definitely in a new investment environment that will bring an even lower wellbeing of the Citizens.
    The second most important data we want to watch is the Trade Balance of China:

    A sharp decrease of the growth or even a recession in the BRICS.

    A decrease of average wages and increase in productivity.

    An increase of the Inventories of Businesses that is higher than the corresponding increase in sales.

    All of these events will lead to a lower GDP.

    A lower employement rate.

    It is then obvious hence that the Fed will not raise its short-term interest rate as a result of increased employment or inflation.


    The Fed has almost no control on Long Term movement of Inflation and Long-Term Yield and the extraordinary measures of Quantitative Easing while having a positive effect on Inflation and Long-Term Yield will be short lived.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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