Rising Rates

Thomas asked, “Are you guys worried about rising interest rates?”

Yes, very. Wednesday of last week saw a rough 5-year bond auction that sent 10-year yields higher, to 3.70%. That was the high of the year, and it got traders talking about whether the government had lost its ability to keep rates down. Remember, the Fed has been working hard to drop rates via its buying of Treasuries. If that isn’t working anymore and rates are in the hands of the free market and the free market wants to take them higher, well, you can see why people are worried that we’re about to re-play That ’70s Show.

From last weekend’s Kelly Letter:

One of the biggest risks remains runaway inflation from rampant government borrowing and the flood of money put on the street in the last year.

Historian Niall Ferguson wrote last Friday in the Financial Times about this subject, as it came up in his recent debate with Paul Krugman:

“‘The only thing that might drive up interest rates,’ [Krugman] acknowledged during our debate, ‘is that people may grow dubious about the financial solvency of governments.’ Might? May? The fact is that people — not least the Chinese government — are already distinctly dubious. They understand that U.S. fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.”

He concluded that, “In the absence of credible commitments to end the chronic U.S. structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings.”

There are, of course, no such credible commitments on the horizon. Indeed, there have been none in the past three decades. About the only bipartisan theory in Washington is that spending solves all — and the more borrowed, the better.

The New York Times picked up on this theme yesterday, noting that “in the last three weeks, the pace of the increase in the 10-year Treasury note’s yield has quickened.” True, and it wasn’t exactly rising at a snail’s pace before that. From the article:

Since the end of 2008, the yield on the benchmark 10-year Treasury note has increased by one and a half percentage points, rising to 3.54% from 2%, the sharpest upward move in 15 years.

Increased rates could translate into hundreds of billions of dollars more in government spending for countries like the United States, Britain and Germany.

Even a single percentage point increase could cost the Treasury an additional $50 billion annually over a few years — and, eventually, an additional $170 billion annually.

This could put unprecedented pressure on other government spending, including social programs and military spending, while also sapping economic growth by forcing up rates on debt held by companies, homeowners and consumers.

So, yes, Thomas, we’re worried.

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