How Much Should We Worry About Interest Rates?

There are two schools of thought about how we should interpret the recent uptick in interest rates on government debt.  Pessimists say this is the inevitable result of all this hog-wild deficit spending; markets are pricing in inflation, and possible default.  Optimists (pronounced "Democrats") respond that it's simply a rebound from the Treasury bubble that followed the financial panic in November.  Back then, investors were literally practically paying the Treasury to take their grubby cash.  Eventually, the market was going to rebound as people who had fled to the safety of treasuries started lending into the broader economy.  So why get so excited about the return to "the highest levels since September 2008"?

The optimists have a point.  But I'm not sure how much of a point.  Treasury yields don't look so bad in nominal terms.  But when you remember that inflation is now in the zero-to-negative range, despite rising oil prices, they look a little pricey.  Real yields on the ten-year are now on the order of 4.5%.  As David Rosenberg of Gluskin Sheff noted in this morning's email:

We have already crammed into six months what it took 48 months to accomplish in the 2003-07 bear market -- to see the 10-year yield soar 180 basis points from the low.  With inflation running at -0.7% YoY, we now have a 'real yield' of 4.5% -- the last five times we got to this level, the nominal yield rallied 50 basis points in the next three months.  As an aside, a 4.5% real government yield and 8.0% real corporate bond yield is serving up some major competition for equities right now.

Moreover, the yield curve is getting steeper.  In layman's terms, this means that rates investors charge the federal government for long-term borrowing are rising much faster than the price of its short-term borrowing.  That signals one of two things, neither of them good:  investors are pricing in expected inflation, or they are pricing in a higher risk of default.

Meanwhile, the evidence of strengthening in other markets is uneven.  Mortgage markets are collapsing as interest rates (usually pegged to US debt) rise.  Corporate debt yield spreads seem to be tightening; state and municipal yields, less so.  But as Rosenberg points out, the real yield on corporate debt has risen along with that of treasuries (though at a slower pace) and is now pretty high.

But perhaps the biggest reason to worry about the rising interest rates is this:  the Fed is buying big blocks of treasuries.  That's the "quantitative easing" you've been hearing so much about.  If rates are rising even though the Fed is in the market, trying to keep credit cheap, that ought to give us pause.  What would they look like if Ben Bernanke weren't trying quite so hard? 

Because eventually, either political pressure or the financial markets will force him to stop.  That's when we'll find out what the "natural" interest rate is.  And I hope we're not in for an ugly surprise.