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Generational Dynamics Web Log for 26-Sep-04
Debate over long-term interest rates

Web Log - September, 2004

Debate over long-term interest rates

Analysts are clearly puzzled over why long-term interest rates have been falling, while the Fed is pushing up short-term interest rates.

This phenomenon, known as "flattening of the yield curve," is a sign of trouble if it continues for long, as we've discussed.

Australia is having a national election on October 9, and Prime Minister John Howard, who is seeking a fourth term, is making interest rates an election issue, by pointing out that short-term interest rates are 5.25% now, and were 7.5% when the Labor government, his opponents, lost power in 1996. "Interest rates will always be higher under a Labor government than a coalition government," Howard said. (I just love it when politicians brag about things they have no control over and probably don't even understand; but if they didn't talk about things like that, they probably wouldn't have anything to talk about.)

However, what analysts in Australia are puzzled about is the same thing that's puzzling American analysts: How can long-term rates be falling, while short term rates are rising?

The Australian central bank has been more aggressive than the American Fed in raising short-term interest rates, which is why the Australian short-term rate is 5.25% (compared to 1.75% in America). But the 10-year bond rate is down to 5.33% in Australia (compared to 4% in America). What these extremely low long-term rates indicate is that the market expects the economy to grow very slowly - around 2% - in the next decade, both here and in Australia. It's a matter of some debate whether the market is right or wrong.

Here in America, the question was debated in an op-ed in Friday's Wall Street Journal, in which financial analyst Brian S. Wesbury considers several different theories to explain the phenomenon.

He considers several different theories: the economy is growing without inflation; oil prices are slowing the economy; dollars held by Japan, China and other countries are finding their way back into the American economy.

In the end, he finally concludes that nothing is wrong: "Many of the theories used to explain the recent decline in long-term bond yields break down under close scrutiny. The best explanation continues to be excessively accommodative Fed policy. ... It is this policy stance, not some imminent economic collapse that is holding down long-rates. As we saw in 2003 and again earlier this year, no matter how many different theories are bandied about, once bond yields shake loose of the Fed, they rise sharply. There is no reason to suspect that this time will be any different."

This is the standard view. He compares today's situation to recent history (2003 and 2004), but overlooks the fact that public debt has become astronomically high in the last year, and he overlooks the fact that stocks are selling at extremely high valuations (measured by price/earnings ratios). To say that "There is no reason to suspect that this time will be any different" is silly. There are plenty of reasons to suspect that this time will be different, and analysts have a responsibility to analyze those reasons, not just dismiss them out of hand.

Wesbury's column illustrates the problem with mainstream analysts. Wesbury considers only a few unsound reasons to explain the current situation, and ignore the really huge issues (public debt and stock valuations).

These are the issues that explain the current situation: Stocks are overvalued by about 100%, but near-zero Fed financial rates are encouraging people to borrow money to purchase them, keeping their prices up. Many companies, burdened by huge corporate bureaucracies, are preserving cash by cutting expenses, and employees. Unemployed people and near bankrupt businesses have mortgaged or sold long-term assets and borrowed short-term money to pay debts. Now that all the homes and other long-term assets have been mortgaged, the demand for long-term debt has decreased, lowering long-term yields, even while short-term yields are increasing (thanks to the Fed). This string is close to running out. (26-Sep-04) Permanent Link
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Generational Dynamics Web Log for 26-Sep-04 Debate over long-term interest rates

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Generational Dynamics Web Log for 26-Sep-04
Debate over long-term interest rates