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Interest Rate Jitters

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This week the stock market experienced a fit of jitters over the possibility that US interest rates are about to rise. Investors are right to be nervous. If interest rates move significantly higher, stock prices are very likely to crash. That is a possibility that certainly cannot be ruled out. However, I suspect that interest rates are more likely to remain lower for longer. I believe this for two main reasons. First, the central banks want and need interest rates to remain low in order to prevent a severe new economic slump. Second, the inflation rate is low and likely to remain that way.

The Fed has hiked the Federal Funds Rate one time (December 2015) during the past 10 years. It may hike again by another 25 basis points in December this year. If it does, the markets will certainly react negatively. However, the Federal Funds Rate is not the interest rate that matters most. The yield on the 10-year US Government Bond is much more important. That is because mortgage rates and the interest rates charged on consumer credit are set at some premium to the 10-year bond yield, rather than against the Federal Funds Rate. It is important to keep this in mind because the Fed does not directly control the yield on the government bond. Furthermore, the yield on the government bonds does not always move in line with the Federal Funds Rate. In 2004 - 2005, the Fed hiked the Federal Funds Rate 17 times, but the 10-year bond yield remained roughly flat.

So, what does determine the yield on the 10-year government bond? The supply and demand for bonds does. The supply is largely determined by the size of the US budget deficit, since the government has to sell new bonds to fund its deficits. When the government budget deficit increases, the government has to sell more bonds and that, all other things being unchanged, tends to push up the yield on bonds. This is called Crowding Out because when the government borrows it tends to push up interest rates and "crowd out" the private by making the cost of borrowing too expensive. In the past, it was this supply of bonds from the government that had the biggest impact on bond yields. But things have changed.

These days, the demand for bonds has much more influence on interest rates than the supply of bonds does. This change has come about due to the introduction of Quantitative Easing.

When the Fed prints money and uses it to buy government bonds, that clearly increases the demand for bonds. It pushes up the bond prices and pushes down the bond yields. The Fed has done this three times since 2008.

The effect is exactly the same when China's central bank, the PBOC, prints its currency, the Yuan, and uses the new Yuan to buy Dollars and then uses the Dollars to buy US government bonds (as it regularly does when it wishes to hold down the value of the Yuan). The PBOC and many other central banks have been doing this for a very long time. Japan's central bank, the Bank of Japan, started doing this in the 1970s, soon after the Bretton Woods System broke down. There is effectively no limit as to how many US government bonds the Fed and other central banks can buy this way.

The yield on government bonds outside the US also affects US government bond yields. Because of Quantitative Easing, Japanese and German government bonds actually have a negative yield. That makes the 1.7% yield on the 10-year US government bond look very attractive, thereby increasing the demand for US bonds.

Finally, the inflation rate affects the demand for all bonds. If the inflation rate goes up, the demand for bonds will go down - unless the yield on those bonds increases. That is because people only want to lend money (or invest in bonds) if they can do so at a rate of interest above the inflation rate. If the US inflation rate does move higher, then bond yields would have to move higher too. But, because Globalization is so deflationary, inflation is much less of a threat than it used to be. Consequently, it seems unlikely that the US inflation rate will move up much any time soon.

So, here's the bottom line. With the inflation rate so low, I believe the Fed will do whatever it takes, including launching another round of Quantitative Easing (if necessary), to make sure that interest rates remain low. That is because the Fed understands that if interest rates go up significantly, the stock market and the property market will fall sharply, causing the US and the rest of the world to go back into severe recession.

For these reasons, I don't think investors need to panic about a sharp increase in US interest rates anytime soon. Of course, I could be wrong……

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Original publish date: September 14, 2016

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