pollyanna stock market bulls continue to attribute the sharp rise in interest
rates to an improving economy, some are nevertheless wondering if higher
bond yields will eventually draw money out of the stock market. The reality
is that no matter how high bond yields rise, bonds will remain lousy investments.
As I have written in the past, the bond market bubble was supported mainly
by speculators and hedge strategies designed to protect mortgage portfolios
from falling interest rates. Now that the momentum has reversed, those
buyers have now become sellers. Speculators will now sell into any rally,
and mortgage portfolio managers, now needing to hedge against rising interest
rates, have become sellers as well. In addition, the U.S. government is
now a much larger seller of debt than it has been in the past, particularly
as its shorter-term issues mature.
So to whom will the government now sell its debt? True investor demand
is simply not there. Americans have little in the way of savings, and
have probably already bought most of the bonds they are likely to buy.
Foreigners are substantially over-invested in U.S. dollar debt, and due
to accelerated deficit spending and excessive money supply growth, they
would certainly be reluctant to buy and hold 10-year bonds to maturity
that yield only 4.5% or 30 year bonds yielding a measly 5.5%. In fact,
foreigners are far more likely to be net sellers of U.S. bonds. Unfortunately,
yields would have to rise substantially before any true investor demand
would develop. The problem is that a yield high enough to attract investors
would also send the U.S. economy, so heavily dependent on low interest
rates, into a severe recession. This would accelerate capital flows out
of the U.S, sending the dollar even lower, thereby causing the interest
rates (the risk premium for holding dollars) to rise further. This self-perpetuating
spiral suggests that there is almost no yield high enough to make U.S.
government bonds a good investment.
As a result, the principal buyers of all of this debt will likely be central
banks, chiefly the Federal Reserve. The more bonds the Fed buys, the less
attractive U.S. bonds become as investments because the Fed simply creates
the dollars necessary to buy these bonds, thereby diminishing the value
of the existing dollars in which all U.S. bonds are denominated. In addition,
as interest rates rise and the U.S. economy weakens, the Federal budget
deficit will become far more severe than is currently forecast. Compounding
the situation will be the fact that higher rates themselves will increase
the cost of financing both the larger budget deficits they produce and
the growing national debt. Again, another self-perpetuating cycle of larger
deficits causing higher interest rates and higher interest rates causing
Stock market bulls dismiss the impact of higher interest rates by maintaining
that interest rates are still low by historic standards. While that may
be true, the operative word is “still.” At this stage, the direction in
which rates are moving is far more important than their current level.
While rates may be low now, they are rising fast. The consumption-driven
U.S. economy, powered by over-leveraged consumers and a real estate bubble,
not only needs extremely low rates to survive, but falling rates as well.
It is unclear exactly how this situation will pan out. Will it end merely
with the worst recession in U.S. history or something far worse? Unfortunately,
I do not think these questions will remain unanswered for much longer