What Are Long Term Interest Rates Telling Us?

Chart courtesy of Prophet.net

Many people have a firm understanding of how interest rates are set but let's briefly explain it for those who might be a little hazy on the topic. It's not like we all sit around studying economics or financial markets. In a nutshell, long term rates are set by buying and selling in financial markets just like stocks. Short term rates are set by The Federal Reserve. So, one could argue that long term rates are determined by natural forces while short term rates are manipulated to achieve an outcome. Hopefully a positive one.

The Federal Reserve has two mandates. Those are full employment and price stability. With the "Fed" raising short term rates to over 5% to combat perceived inflationary problems, the ten year bond and ten year interest rates are still hovering at the same price it was five years ago. The chart above is that of the ten year bond. The y-axis is the interest rate slid on decimal to the right. ie, 52 on the chart is a 5.2% interest rate. Financial markets tend to discount today's information and price information into what is happening six to twelve months from now. So, while the Fed jams short term interest rates to 5.25%, long term rates aren't rising significantly. Thus, the market isn't voting with the Fed that the problem is inflation or long term rates would likely be substantially higher. What are ten year rates telling us about six to twelve months from now? Well, unless they start headed higher and significantly higher, they are telling us the future expectation is that there is no inflation demon. That leaves a few possible scenarios to ponder. 1) Global growth will continue without inflation being a problem. 2) We are headed towards a slow down and that slow down may be deflationary versus inflationary.

Why do I throw in the deflationary comment? Well, for many reasons. I'll give you four to keep my typing down. Gold, hard asset prices, low long term interest rates and China. Gold has been on a tear this cycle. Gold usually rises rapidly under one of two scenarios. Those are either inflationary pressures or deflationary pressures. It is a hedge for either outcome. We all know that short term (this business cycle) there has been hard asset inflation. That has manifested itself in the form of housing prices exploding, industrial metal prices exploding and energy prices exploding. In fact, many of these have seen price appreciation unequaled in the last one hundred years.

So, we have hard assets at very elevated levels if not bubble levels, we have a likely bubble in their corresponding stock prices, we have gold rocking upward and we are likely near the peak of the economic cycle. So, if we have a slow down which is nearly inevitable, what will happen to all of these hard asset prices? They will drop and if history is a guide, they could implode. So, where's the long term inflation in this scenario? There isn't any. Short term inflation driven by a massive global liquidity glut and long term deflationary pressures once that liquidity glut is taken away. Basically, we didn't beat the deflationary devil that central bankers feared post 2000, we likely just shuffled the deck before dealing the final hand.

Synchronized global growth and excess liquidity do not mix. They jointly create a tremendous strain on the system. The last time we had three years of such high sustained global growth was the early 1970s. We also had an asset price explosion which followed a stock market bubble just like today. The potential difference is inflation did take hold and it stuck in the 1970s. Why? Because wage inflation took effect. You see, consumer inflation cannot take hold unless the consumer's wages are going up to pay for inflated goods. Today they aren't. At least, not yet. And, I'm suspect that they will not unless we can keep this party going for quite a bit longer. If we do and it does (figure that one out!), the party will just get uglier. Because then we'll really get a jump in Fed rates and that will surely kill consumer spending and global growth. But, hold on! Why won't that likely happen? Because China is melting down right now and they have massive deflationary pressures building to a crescendo in their economy.

So, what happens as China begins to crater? They flood the world market with cheap goods to try to keep the dream going cause there isn't anyone in China buying anything. ie, Exports are the only way for them to shovel all of that shit onto someone because they have not reformed their economy to drive consumer demand. This could possibly be the fuel to ignite the cycle of deflationary pressures. Sounds like.............1929. While no one can predict the future and that is a doom and gloom outcome, there just might be some truth to its possibility. It doesn't need to end up with another Great Depression but then again, no one knows. More on that one in another post.

What's the moral of the story? No free lunches. Never has been and never will be. The world has been on a growth and spending binge for more than a decade. When these types of excesses build, historically the only way out of this mess is a cleansing of the system. Japan found that out with 17 years of deflation and 17 years of falling stock prices. It's pay me now or pay me later because there ain't no such thing as a free lunch.