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Why Interest Rates Are Rising
The interest rate on the Ten-year Note has risen from 1.58% on December 6th of last year, to as high as 2.03% by mid-February. Most equity market cheerleaders are crediting a rebounding economy for the recent move up in rates. According to my count, this is the 15th time since the Great Recession began that the economy was supposedly on the threshold of a robust recovery.
However, the reading on last quarter's GDP growth was negative, while the January unemployment rate actually increased. Therefore, it would be ridiculous to ascribe the fall in U.S. sovereign bond prices to an economy that is showing signs of an imminent boom.
The truth is that rising bond yields are the direct result of stability in the European currency and bond markets, the inability of the U.S. to address its fiscal imbalance, and a record amount of Federal Reserve debt monetization.
The Euro currency, which was thought to be on the endangered species list not too long ago, has surged from $1.20 in the summer of 2012, to $1.36 by the beginning of February. In addition, bond yields in Spain and Italy have recently fallen back to their levels that were last seen just before the European debt crisis began. Renewed confidence in the Euro and Southern Europe's bond markets are reversing the fear trade into the dollar and U.S. debt.
Washington D.C. was supposed to finally address our addiction debt and deficits in January of this year. Instead of refusing to raise the debt ceiling and allowing the sequestration to go into effect, our politicians seem to be able to agree on just one point; that is to delay austerity. President Obama claims that the nation has already cut deficits by $2.5 trillion over the last few years. Nevertheless, the fact is that deficits have totaled $3.67 trillion in the last three years alone! The absolute paralysis of Congress to agree on a genuine deficit reduction plan has finally given bond vigilantes a wakeup call that was long overdue.
Finally, the Fed increased its level of money printing to $85 billion, from $40 billion on January 1st. This record amount of debt monetization comes with unlimited duration and is accompanied by an inflation target of at least 2.5%. The Fed's actions virtually guarantee that real interest rates will fall even further into negative territory, despite the fact that nominal rates are rising.
So how high will interest rates go in the short term? It seems logical to figure they will increase at least to level they were prior to the European debt crisis. Back in the fall of 2010, just prior to the spike in Southern Europe's bond yields, the interest rate on the U.S. benchmark Ten-year Note was yielding around 3.5%. Therefore, unless there is another sovereign debt crisis in Europe (or perhaps one starting in Japan), I expect interest rates to trade back to the 3.5% level in the next few quarters.
This means U.S. GDP growth will be hurt by the rising cost of money and the tax hikes resulting from the January expiration of some of the Bush-era rates. Rising tax rates, one hundred dollars for a barrel of oil and increasing interest rates significantly elevate the chances of a recession occurring in 2013.
Since rates are increasing due to debt and inflation concerns, it also means the Fed will have to decide between two very poor choices. It would never choose to stop buying new debt and start selling its $3 trillion balance sheet, as that would send bond yields soaring in the short term and the unemployment rate into the stratosphere. So investors can't really count this as a viable option for Mr. Bernanke. He could simply do nothing and watch another recession ravage the economy--not a high probability given the Fed's history. Or, Bernanke most likely will be forced into embarking on yet another round of QE in an attempt to keep long-term rates from rising further.
This would be the most dangerous of all the Fed's options as it will send inflation soaring and cause interest rates to rise even higher down the road. The resulting chaos from violent interest rate instability is the main threat to the stock market and the economy in the very near future.