The Most Important Number In The World

The Most Important Number In The World

My finance professor at business school once told my class that the most important number in the world of finance is the yield (i.e. the interest rate) on the 10-year US government treasury bond. US government bonds are considered risk-free. The interest rate at which all other bonds can be sold is determined by this risk-free rate on US government bonds plus a risk premium, which depends on the credit worthiness of the debt issuers. Therefore, when the yield on the government bond rises, the interest rates on mortgages, corporate bonds, credit cards and student loans also rise. Similarly, when the yield on the government bond falls, the cost of all borrowing falls.

Most financial analysts expected the government bond yield to rise significantly this year. Instead, it has fallen sharply. This week, it fell to 2.40%, an 11 month low. May will be the fifth month in a row that yields have fallen. In this blog, I would like to give you my explanation for why interest rates are falling.

In business, everything has a price; and that price is determined by supply and demand. Interest rates are the price a borrower is willing to pay to borrow money. In the past, when gold was money, the supply of money did not change (or it changed very slowly). So, then, it was only changes in the demand for money that caused interest rates to rise and fall. For example, if the economy was growing rapidly, businesses would tend to borrow more to take advantage of the profitable investment opportunities the booming economy presented. The business sector’s increased demand to borrow money would cause the price of borrowing (interest rates) to rise. And, by the way, after some time, the higher interest rates would make investing less profitable, so the economy would slow again.

Using another example, if the government borrowed a lot of money to finance a large budget deficit, that government demand for money would push up interest rates. Higher interest rates would make it less profitable for the business sector to borrow and invest. In such an instance, it was said that government borrowing was “Crowding Out” the business sector, and thereby damaging the economy’s growth prospects.

These days, the situation is more complicated. Once the government stopped backing dollars with gold in 1968, the supply of money was no longer fixed because the government was free to create as much money as it thought desirable. So, now, it is both the demand for and the supply of money that determines interest rates. In other words, to understand why the interest rates on government bonds are now falling, we must consider not only how much money the government is borrowing, we must also consider how much money the government is supplying (i.e. creating) through Quantitative Easing (QE).

When we look at it that way, it becomes immediately apparent why interest rates are currently falling. During this quarter (the second quarter of 2014), the government expects to have a large budget surplus of $78 billion. That means the government will not have to borrow any money at all on a net basis this quarter. Meanwhile, the Federal Reserve will create $145 billion through QE and inject it into the financial system by acquiring bonds. Therefore, the government supply of money will greatly exceed its demand for money this quarter. That, in my opinion, is why the yield on government bonds is falling.

Falling interest rates help the economy expand by making investments more profitable and by causing property and stock prices to rise. Unfortunately, this favorable balance between the government demand for and supply of money will disappear during the third quarter. The government is expected to once again have a large quarterly budget deficit, which will require it to borrow more. However, the Fed, which is tapering its QE program, will supply a great deal less new money. Consequently, the balance between the government demand for and supply of money will once again turn unfavorable, and that is likely to cause government bond yields to start rising again. By the fourth quarter, when QE is scheduled to end altogether, the balance between the government’s demand for and supply of money will become very unfavorable. That could cause interest rates to move considerably higher. If so, business investment would suffer, property and stock prices would probably fall sharply and the economy would very likely move back toward recession.

That is the scenario I consider most probable for the second half of this year. If it unfolds as I expect, I believe the Fed will be forced to launch a new round of Quantitative Easing, QE4, to prevent a severe new deflationary global economic downturn. If the Fed does inject additional liquidity through QE4, it would very likely push bond yields lower and stock prices and property prices higher again.

In this new age of fiat money, Liquidity (or, in other words, the balance between the government’s demand for and supply of money) determines the direction in which stock prices, property prices and commodity prices move. If you are interested in learning more about how I measure Liquidity, visit my website:

http://www.richardduncaneconomics.com

 

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