My piece in today’s Fin puts the argument that long-term US interest rates must rise in view of the many pressures (increasing inflation, massive trade and budget deficits) in that direction, and that intervention to hold them down will eventually fail. (I’ve put it over the fold)
Coincidentally, the US trade deficit for November came in at $60 billion, easily breaking the previous records, and despite lower prices and a sustained devaluation relative to the euro, $A and other currencies (though not the Chinese renminbi).
This was, as far as I can tell a surprise to the markets (unchanged at $55 billion) was the par prediction, and the US dollar promptly weakened. But the 10-year bond rate remained unchanged. This makes no sense at all, but I’ve given up expecting financial market outcomes to make sense. General Glut has a chart from Robert Scott of the Economic Policy Institute on another aspect of the puzzle as well as detailed commentary on the trade figures summed up by the observation This report is ugly 1000 ways till Sunday
I think a partial resolution of the puzzle in the Scott chart is that the last turnaround in the trade deficit was achieved through a combination of depreciation, budgetary tightening, higher interest rates and demand contraction (that is, a recession). The same was true, broadly speaking, in Australia. There is, in general, no painless way of fixing a trade deficit on this scale.
In one of the most famous Sherlock Holmes stories, Silver Blaze, the crucial clue is the curious incident of the dog that did not bark in the night. Holmes infers that the burglary at the centre of the case was an inside job. The dog would have barked at an intruder, but not at a familiar person.
The dog that did not bark in 2004 was the international bond market, in its pricing of long-term US government debt, and particularly 10-year Treasury notes.
On all the standard rules, the rate of interest on 10-year notes should have risen substantially. The Federal Reserve increased the cash rate six times, reducing the margin between short and long rates. Inflation rates increased and higher oil prices seem likely to feed into more inflation in the future. The US dollar depreciated against the euro and, in view of the steadily increasing trade deficit, seems certain to fall further.
The long-term outlook for the US Budget deteriorated through the year and was greatly weakened by the re-election of the feckless Bush Administration, whose supporters assert that budget deficits either don’t matter or are a positive sign of economic strength. Such attitudes would normally merit severe punishment from bond markets.
Yet the dog did not bark. The 10-year rate was about 4.2 per cent at the beginning of 2004, rose to nearly 5 per cent at mid-year then fell back, ending the year almost exactly where it started. Conversely, the market price of 10-year notes fell somewhat, then recovered.
What are we to make of this? If the interest rate was being set by standard market forces, it would certainly have risen. So we must infer an inside job, with the rate being set by some form of manipulation.
Most attention has been focused on the demand side of the market. Private investors have increasingly pulled out of assets denominated in US dollars, selling both equity and debt. The slack has been taken up by Asian central banks, particularly those of China and Japan.
Some have called this pattern of intervention ‘a new Bretton Woods system’. But it cannot continue for long. To see this, it is only necessary to look at the losses the Chinese government will take on its dollar holdings when the peg between the renminbi and the US dollar is, inevitably, broken. With reserves of $600 billion, a ten per cent appreciation of the renminbi would cost the People’s Bank $60 billion, or about 25 per cent of the government’s annual budget. The more reserves are built up to defend the peg, and the further it gets out of line with market reality, the greater the eventual cost.
Much less attention has been paid to the supply side, but it is probably more important. The main reason that the price of long-term US notes and bonds has not fallen is that there are less of them on the market. This is a surprising observation, given that the US government is running large budget deficits.
The explanation is that, in the past few years, the US has drastically shortened the term of its borrowings. Just when the government went into deficit in 2001, the US abandoned the sale of 30-year bonds, although the interest rate on these bonds was historically low. More generally, long-term bond financing has been replaced by shorter-term bills and notes.
As New York University economist Nouriel Roubini has noted, the average maturity of newly issued US government debt has fallen from 90 months in 1999 to 34.2 months by September 2004. The average maturity of the total debt has fallen from about 70 months in 2000 to 55.1 in September 2004.
For any normal borrower, this kind of shortening of borrowings would signal an imminent rollover crisis, as creditors refused to renew the debt except at much higher interest rates. Even before this happened, speculators would be discounting the debt in secondary markets. The coup de grace would be a speculative raid similar to that by George Soros, which pushed Britain out of the European Exchange Rate Mechanism in 1992.
For the moment at least, few speculators are willing to take on the combined might of the US Federal Reserve and the People’s Bank of China. But no central bank, no matter how powerful, can hold asset prices up indefinitely. Sooner or later, US interest rates must rise, and anyone who is still holding US debt will be left to take the resulting loss.
John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.
John Quiggin 
Robert Barro in a recent Business Week made some of the points you do. The riddle is why the market mechanism does not force the US to raise interest rates to sustain what seems to be the unsustainable.
Barro points out that while officially held debt is rising it is still only a small fraction of the total — about 14%. The US is borrowing like crazy from the international private sector but being charged almost nothing to do so.
Indeed up until the present it is still a net interest income earner on international debt since returns on its foreign investments are high. This should change this year.
I enjoyed your AFR piece.
This is a brilliant analysis. Surely Pr Q should follow up his dismal theory by the practice of shorting T-Bonds? Commentators could pool our funds to break the bank of the US Treasury and assist in the defeat of the Bush admin. I am happy to toss in some lazy bucks.
Talk about doing good by doing well!
The US currency cannot fall as long as it continues to “take out the garbage” ie. do the jobs that no other country want to do. e.g. maintain it’s security posture against N.Korea, maintaining a demilitarized Japan, and then all the work in Iraq and Afganistan. China cannot afford for the US to fail here, or risk disrupting it’s own oil supply.
As I’ve pointed out repeatedly, Jack, I can say what must happen but not when. If I’d followed my own advice I would have shorted the NASDAQ when it reached 2500 in 1999. The market can stay irrational longer than I can stay solvent, especially when the People’s Bank of China and the US Treasury are helping.
A fair few fund managers got burnt badly on this stuff, following JQ’s line and I think deep down everyone wants to be on the trade, but they all have memories. Something has to give and everyone will say we saw it coming, but you might have to be a bit patient yet. I don’t think China is beholden to anyone and they will let the CNY appreciate when they are ready. Anyone who looks for an early response from SAFE is being pretty optimistic in my view…so we’ll probably carry on like this for a bit longer yet.
No need to get testy Pr Q! I was actually, for once, being dead serious when I described Pr Q”s analysis as “brilliant”.
The key insight is the way the US Treasury has been able to artificially depress the long term yield curve of US Treasury bonds by altering the composition of its T-bond auctions to shorten the average term of any given bond.
With more shorter-term bonds on sale, being continually rolled over, there is a lower risk-premium for any given lump of credit. This means that secondary borrowers will face lower interest rates.
It is interesting to speculate on how much “Mayberry Machiavellianism” went into the change in the term composition of US debt portfolio.
The massive sales of T-bonds have helped the US admin to sting the Chinese Peoples Bank to the tune of tens of billions of dollars. It has also enabled a general consumption binge based debt-fuelled inflated asset realisations and easy consumer credit.
This has certainly improved Bush’s re-election chances, more so than the tax-cuts which were probably invested in overseas shares or property.
So Bush’s T-bond scam has screwed the PRC and the DEMs. Long enough to privatise social security and flatten tax-rates before the inevitable bond market crash and recession. Thats whats called allowing the market to become economicly irrational long enough for the party to cash in on its political solvency.
This might seem a dumb question, but if US interest rates go up substantially, Australia’s interest rates will also go up a similar amount, won’t they? And that will have pretty catastrophic results through the mortgage belt, won’t it?
Robert,
No, not necessarily. Home loans in Australia are usually variable rate, and priced off the official cash rate, set by the RBA. We will only face higher home loan rates if the RBA decides to increase interest rates. That seems unlikely while we have low inflation.
Long bond yields for government and corporate borrowers, however, are a different story, and there may well be a significant increase in our bond yields if the global cost of capital increases.
I think John (comment 4) has hit the nail on the head with the reasons for the maintenance of this disparity. The US economy is able to maintain this position only while the Chinese leadership insists on maintaining the peg to the US dollar – running a huge trade surplus with the US would normally mean an adjustment to the USD – yuan exchange rate, which the Reserve Bank of China is cancelling out by buying US dollars. The result is that the two policies hold each other in equilibrium – while the political will on the Chinese side is maintained. China is not the only one doing this, but it is the main one. This situation cannot run forever, though. The USD reserves in China will build up to the point where they have to break the peg and the whole edifice will collapse.
The longer this goes on for, the bigger the collapse will be. The only question is when the Chinese will pull out – I cannot see the US deficits being reduced any time in the near future.
One interesting thing is that this is another reason why the market, not governments, should set the exchange rate. The governments are letting the bubble inflate – when it pops, as it must, the consequences will be harmful. The market would have already adjusted the USD – Yaun rate to reduce this effect.