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Tapering Does Not Explain Rising Interest Rates

People worry out loud about tapering, despite good evidence that the fed would never taper in a significant way. All this worrying is supposed to have caused the run up in bond yields over the last 6 months.

But stocks haven't manifested worry about a taper; they act like the Fed has their back.

Some bond investors probably dumped bonds over their worries about tapering. But there's a better explanation for rising yields than taper fears.

When the money supply increases in response to QE, company revenues get bid higher. The revenues rise much faster than costs, which are lagged historically by accounting rules. So the money printing increases average profit margins, even as it depresses interest rates. Long term rates are somewhat depressed by Fed buying of long term bonds; short term rates are nearly zeroed out by the flood of excess reserves caused by QE.

Money printing creates a situation in which firms enjoy high profit margins, against which they can borrow at very low and profitable rates of interest. This large disparity makes long term interest rates want to go up. Short term rates cannot go up, because excess reserves wipe out fed funds borrowing.

As long as the Fed keeps pumping enough new money into the system, profit margins will remain artificially high. As long as margins remain historically elevated (from both the money pumping and from big government spending--which is another subject), long term rates have real reasons to keep climbing.

Rates will fall again only as costs catch up with revenues, taking margins down again. This process happens when the rate of money printing levels off for a considerable time. So costs then have an opportunity to rise from past money printing, which reduces profit margins, which decreases demand for business goods, which slows the rates of revenue growth. Revenues can even decline, despite the constant rate of money printing, when worried firms and households try to spend less to shore up cash balances.

Then the recession begins, a process that ends the wealth destruction of the false Keynesian boom. When the recession begins, rates tend to follow profit margins back down again.

My guess is rates still need to rise for a while.

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