The coming rise in Interest Rates

If the US Federal reserve decides that inflation is its greatest threat and decides to stop the pumping of cash into the banking system then the 1994 history could repeat itself with a vengeance in 2010

The Federal Reserve was ultra-dovish about the prospects for the US economy and inflation, as the November FOMC conclave promised to keep the policy rate (the Fed funds rate) “exceptionally low for an extended period”. The US unemployment rate has risen higher to 10.2 per cent. However, it is imprudent to be too complacent about the prospects for interest rates, as too many investors in the Gulf, who finance risk assets, do when they borrow short-term money to buy high yield bonds, shares and even commodities. Why?

One, long term US Treasury note yields have begun to creep higher as economic data (ISM, third quarter GDP, net exports, and industrial production) suggests the US has emerged convincingly from the worst recession since the 1930s. A 3.5 per cent yield on the ten-year US Treasury note is at least 200 points below the average for the last two decades. Long rates are abnormally low only in the last two decades because US banks, flush with deposits, decided to buy Uncle Sam debt, not increase their loan books. Yet as the economy revives, banks will increase their loan books while selling government securities.

Credit easing
Two, the Federal Reserve bought almost $1.5trn in Treasury bonds and mortgage backed securities, Bernanke’s fabled credit easing to avert a second Great Depression. However, as the money market wounds heal and credit risk-spreads compress to pre-Lehman levels, the central banks must necessarily unwind their liquidity support programmes. This suggests, ipso facto, that dollar interest rates must move higher.

Three, central banks have begun to tighten interest rates as the global business cycle turns, led by China’s trillion dollar bank lending spree and 9 per cent GDP hyper growth. Norway and Australia have raised interest rates. China, India and South Korea could well be next. The ECB’s Trichet has expressed concern about inflation risk. Brazil has imposed a tax on hot money inflows. Net result: Global rates are moving higher. US rates could well follow.

The commodity effect
Four, gold has risen almost $400 an ounce since the immediate post Lehman aftermath. Crude oil has surged from $32 to $80. Inflation risk is priced into commodities, not government debt. Yet if the US Treasury bond market incorporates a higher inflation risk premium, the ten-year note yield will surge from its current 3.5 to five per cent by sometime next summer. This will cause mayhem in the global financial market and could well trigger another stock market and oil price collapse. In any case, if oil prices spike above $100, the global economy will have to confront the demons of inflation, not deflation. The surge in gold suggests that the Fed is behind the curve on inflation. Five, Obamanomics is a fiscal nightmare. The US budget deficit could well be almost $2trn in 2011. So supply risk will overwhelm the US Treasury debt market at the precise moment when commercial banks reduce their holdings to finance loan growth and the central banks unwinds TALP. This is a classic formula for a bond market massacre. No budget deficit reduction is plausible now.

Threat of inflation
Six, the spread between two-year and 10-year US Treasury bond yield has surged to record highs. This means the yield curve prices in higher economic growth and hawkish Fed policy response. The bond market is on the edge of an epic sell off, a bloodbath similar to 1994, when major banks and hedge funds collapsed as the Greenspan Fed unexpectedly tightened monetary policy to pre-empt inflation. History could repeat itself with a vengeance in 2010 if the Fed decides that inflation, not a double dip recession, is its greatest threat and decides that Helicopter Ben’s monetary pump must stop pumping cash into the banking system. I can easily envisage the two-year Treasury note yield at 2.5 per cent and ten-year T-note at 5 per cent if the central bank decides that it is time to tighten.

The bearish bond market scenario has profound implication for GCC investor. Short-term borrowing rates could well hike. The dollar could well surge against the Euro even as crude oil prices and gold plunge. GCC sovereign bond credit spreads could spike higher. Emerging markets would fall in unison, bringing the GCC summer rally to a premature end. This is the time to sell greed, buy fear. Unfortunately, the GCC investor believes in short finance, long risk assets (property, equities and oil), a recipe for disaster as the interest rate carry trade de jour unwinds.

Gold has surged to all time highs, unlike crude oil and silver. The Indian central bank’s move to buy 200 tonnes of IMF bullion proves that gold is now a de facto reserve currency for the world’s elite central banks. Sri Lanka, whose government finally vanquished the Tamil Tigers and ended a 25-year civil war, has begun to accumulate gold, whose prices have risen in Euro, yen and sterling. Central banks in emerging economies have, in essence ignited a stealth global run on the dollar. This alone increases the risks of an epic disaster in the US Treasury bond market next year.



 

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