Interest Rates Levitate

Everyone is talking about the significant move increase in US Treasury yields over the past month. The first chart below shows the historical trend for the yields well the lower chart from Pimco shows current treasury yields as of 6-11-2007:

There are a million things that we can talk about relative to the credit markets: inflation expectations, credit spreads, yield curve - the list goes on and on - are all indicators to watch as they reflect the participant's expectations regarding the underlying economic fundamentals.

Today though I'd like to discuss an issue which is a bit narrower. I have heard a lot of talk on CNBC and Bloomberg recently by the pundits pointing out that interest rates are rising because the economy is not slowing and growth is expected to accelerate over the second half of the year. As a result interest rates will have to rise to meet the demand for credit and slow this red hot economy.

I am going to take the other side of this one. I don't see how we can talk about red hot economic growth when Q2 real GDP came in at an adjusted 0.6% so far. How is sub-1% annualized growth - considered accelerating? I guess the argument is that everyone has estimates accelerating to 2 or 3% annualized real GDP growth in Q2 - Q4. To this I will just say - I will believe it when I see it.

Let me offer an alternative theory. US interest rates and treasury yields are increasing due to inflationary expectations and more specifically an expectation of dollar DEPRECIATION relative to the rest of the developing world's currencies. While the USA sits tight at 5.25% on the Fed Funds the rest of the world is actually still tightening interest rates. Although there NOMINAL interest rates are significantly lower in some cases than our rates here in the USA (re: Europe and Japan) - the REAL interest rates can actually be significantly higher when you contemplate both the potential currency appreciation and lower inflation rates in the other countries.

As a result US bonds are being sold off to a level where the the real interest rates when factoring in such issues as inflation and currency appreciation / depreciation make the bond returns more or less equal across countries. Right now the bond market is signalling that nominal rate is significantly higher than 5% in the USA.

The interesting fact is that the credit market does not operate in a vacuum. As interest rates rise in the treasury market - 30 year mortgage rates also rise for residential real estate, and interest rates for corporate bonds also increase ( the exact spread between treasuries and residential mortgage back securities or corporate debt - is the issue of credit spreads - any sign that the spread is increasing is typically a signal of investor aversion to risk and a potential flight to quality.)

The rising interest rates inevitably slow real GDP growth and affect asset valuations such as real estate, businesses, and commodity markets. There is then an expectation that when growth slows enough the Fed will again lower interest rates in order to jump start the economy and prevent too severe of a credit contraction in the banking sector.

Basically imagine a tug of war between the bulls and the bears where the line in the middle is some interest rate on treasuries between 5 and 10%. I do not know what the magic rate is - but at some point if interest rates rise high enough assets prices will collapse. You do not have leveraged buy out mania or a real estate bubble when interest rates go back to 10 year highs. ( We are obviously not even close to that yet.)

I guess in summary the question is what is driving yields up? Is the US economy really booming? Do the higher yields reflect greater inflation expectations? If so is the inflation expectation related to higher growth of the economy or just growth in the money supply? Or is it instead a commodity price issue re: oil and natural gas?

I don't know for sure but I am skeptical that the reason the treasury yields are rising right now is because we are experiencing a "re-acceleration" of the US economy over the remainder of 2007. If that was the case I don't think that my home city of Chula Vista would be in the top-10 places in California for foreclosures.

Best regards,

BG