Thursday, March 15, 2012

Is This The Beginning For Higher Rates?

The Federal Reserve chairman, Ben Bernanke, talked this week and markets moved.  There was nothing really significant that Bernanke said though.  The Dow surged passed 13,000.  Gold tumbled this week.  However, I think the most significant news is in the bond market.

Bonds got hammered this week.  The 10-year yield has been around 2% or a little lower for quite some time now.  While it was hovering just above the 2% mark earlier this week, the yield is now 2.28% as of this writing.  While a few days don't necessarily make a trend, a rise in interest rates has to start somewhere.

The 10-year yield and mortgage rates tend to be highly correlated.  That means that when the 10-year yield goes up (as it has this week), then mortgage rates are also likely to rise.  If the rate were to keep going up, even to just 3%, this could be devastating for the housing market.

Many libertarians/ Austrian school followers have been predicting higher rates in the U.S. for quite some time now.  It hasn't happened yet, like it did in the 1970's.  It never ceases to amaze me how long things can take to unfold.  It seems that the interest rates in Japan should have gone way up, yet the rates there continue to be close to zero.

The Japanese government has a debt-to-GDP ratio that is well over 200%.  This makes the U.S. government look fiscally responsible in comparison.  The Bank of Japan has not inflated much in comparison to other central banks.  But how could a government with such high debt manage to keep rates so low?  You would expect at some point that investors would stop buying government debt, which would either force the government to cut spending or force the central bank to monetize the debt (inflate).  Yet this hasn't happened.  The only explanation is that these investors are naive and do not understand what is going to happen.

This just goes to show that markets are unpredictable.  You may think it is a rational response for investors to stop buying Japanese government debt because the debt has reached such a high point.  Yet, others do not see it this way.  They may not be smart, but it also wouldn't have been smart to bet against Japanese bonds at this point.

I don't think the U.S. government and the Fed will be able to stop higher interest rates for decades like has happened in Japan.  Higher interest rates and higher price inflation are the two main things to look out for.  These two things will determine Fed policy.  I believe the Fed will stop inflating when the U.S. dollar is severely threatened.  At that point, the government will finally be forced to make real cuts.

Higher interest rates will be bad for the elitists in Washington DC.  In many ways, higher interest rates would be a blessing for the long run, as it might slow down the train and lessen the impact of the coming wreck.

We will keep an eye on the 10-year yield and see if the higher rates become a trend.  This could change Fed policy and encourage a start to QE3 (more money creation), but it will eventually bring on the day of reckoning.

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