Friday , 29 March 2024

Why Interest Rates Will Explode Higher Starting Later in 2010

Financial pundits have been cheering the declining U.S. trade deficit, but they should be careful what they wish for. Once the U.S. is no longer running a huge trade deficit, then all those exporter nations will no longer have hundreds of billions of dollars floating around, looking for a home in Treasury bonds. Interest rates are about to start rising, and will continue rising for a generation. Words: 782

In further edited excerpts from the original article* Charles Smith (www.oftwominds.com) goes on to say:

The Fed has created massive artificial demand for more U.S. debt in two ways:
1. by direct purchase of bonds being auctioned and
2. by secretly buying Treasury bonds from “primary dealers” (banks) which give the appearance that some private parties are actually buying T-bills to hold, when in fact they are only temporary proxies for cloaked Fed purchases.

Now, however, as the Fed ends some of its lavish support of the Treasury debt and Congress and the Obama Administration are stepping up their borrowing to unprecedented levels it begs the question as to who will be the “buyer of last resort”. It won’t be China for a number of reasons:

1. When China’s trade surplus with the U.S. was expanding into the hundreds of billions every year, the Chinese needed a place to park all those dollars. U.S. Treasury bonds were liquid, supposedly safe and available in limitless quantities. Keeping interest rates cheap for their American “consumer” debt junkies made good sense as well. Now, however, the gargantuan trade surpluses are shrinking, and the torrent of dollars has diminished.

Financial pundits have been cheering the declining U.S. trade deficit, but they should be careful what they wish for. Once the U.S. is no longer running a huge trade deficit, then all those exporter nations will no longer have hundreds of billions of dollars floating around, looking for a home in Treasury bonds.

2. China holds about $2.27 trillion in foreign reserves, about two-thirds of it in US dollars, making it the world’s largest holder of US Treasuries outside the United States, according to the US Treasury Department. Now, however, it has fewer dollars to park in T-bills and has started trimming its holdings of long-term Treasury debt.

OK, let’s add this up: the two primary sources of demand for new Treasury debt are scaling back or even dumping their holdings, while supply of new Treasury debt is increasing at record levels. Thus, according to the laws of supply (increasing rapidly) and demand (falling), the Treasury’s ability to palm off hundreds of billions in new debt every few months is about to outstrip demand by a long shot. The only way to increase demand will be to raise interest rates, which will then spread to all layers of the economy. All interest rates will rise, including mortgages.

There really is no escape from this conclusion and this is about 2010 through 2035, as bond rate cycles tend to run between 18 and 26 years. Just as interest rates fell for 26 years, now they will rise for a generation or so.

For those who think the newly frugal American household or corporation will step up and buy the $1.4 trillion in new debt and the $2 trillion in debt being rolled over each and every year–dream on. American households were, in fact, net sellers of Treasuries in the second quarter of 2009, and on a massive scale. Purchases by mutual funds were modest, while purchases by pension funds and insurance companies were trivial. The key, therefore, becomes the banks.

a) U.S. banks’ asset allocation to government bonds is about 13 percent, which is relatively low by historical standards. If they raised that proportion back to where it was in the early 1990s, it’s conceivable they could absorb about $250 billion a year of government bond purchases but that’s a big “if.”

b) That just leaves two potential buyers: the Federal Reserve, which bought the bulk of Treasuries issued in the second quarter; and foreigners. Morgan Stanley’s analysts have crunched the numbers and concluded that, in the year ending June 2010, there could be a shortfall in demand on the order of about a third of projected new issuance.

If the Fed and Chinese cut back, due to not having more dollars to squander on T-bills or from various other constraints, then the pressure to sell Treasuries at whatever the market demands could cause rates to explode higher, to the surprise of virtually all observers.

*http://seekingalpha.com/article/179827-why-interest-rates-will-almost-certainly-rise-in-2010

Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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