Treasury yields are rising and investors are looking for a cause. There is now an ongoing battle between two leading economic pundits, Nobel prize winner Paul Krugman and economic historian Niall Ferguson, on what is the cause for this rise. Krugman has argued that the increase in interest rates is positive because it is an indication that investors want to take on risk and the economy is getting better. Ferguson argues that inflation expectations are higher, credit risk is growing, and the funds available to meet the supply of new Treasuries will not be present. The rise in rates is a bad signal.
Unfortunately, both economists are right and both arguments have problems. We will only learn later which argument better represents reality; nevertheless, we find the Ferguson arguments more compelling in the long-run for three reasons.
First, inflationary expectations are rising. No, the US economy will not have hyperinflation. There is no Mugabe effect. However, inflation over the next 10-years will not be zero. There is clearly less likelihood of zero inflation over the life of a long-term 10-year bond.
Even with current CPI at around zero, the core CPI has been somewhat sticky at about 1.7% . The TIPS market for 10-years is forecasting 2% inflation over the next 10-years. The Fed wants some inflation and will run their balance sheet to allow or create positive inflation. There is even talk of an explicit inflation target to get prices higher. Nominal rates should be expected to rise in this environment. Clearly a portion of the rate increase is expecting inflation over the longer-run. What is surprising is that for 2-year Trasuries, the expected breakeven inflation is also about the same as for 10-years. The market does not believe a deflation story. It did back at the end of last year.
Second, the systemic risk of financial failure has been abated. he flight to quality along the entire yield curve should see some reversal. We are now seeing assets move from the Treasury market into riskier securities. This adjustment of portfolio risk will lead to falling spreads on corporate bonds and a rise in Treasury yields which is what has happened since the beginning of the year and what Krugman is arguing a a positive.
Offsetting some of the systemic risk story is the longer-term triple-A rating issue. The credit rating of the US is being called into question with rating agencies concerned about the size of US government debt to GDP. This may reach the 100% mark if the the deficit trends are not reversed. We expect that this will have lead to an increase in rate risk premiums; however, the size of the increase is unclear. The impact of lower rating in Japan, for example, is hard to measure albeit probably higher.
Unfortunately, both economists are right and both arguments have problems. We will only learn later which argument better represents reality; nevertheless, we find the Ferguson arguments more compelling in the long-run for three reasons.
First, inflationary expectations are rising. No, the US economy will not have hyperinflation. There is no Mugabe effect. However, inflation over the next 10-years will not be zero. There is clearly less likelihood of zero inflation over the life of a long-term 10-year bond.
Even with current CPI at around zero, the core CPI has been somewhat sticky at about 1.7% . The TIPS market for 10-years is forecasting 2% inflation over the next 10-years. The Fed wants some inflation and will run their balance sheet to allow or create positive inflation. There is even talk of an explicit inflation target to get prices higher. Nominal rates should be expected to rise in this environment. Clearly a portion of the rate increase is expecting inflation over the longer-run. What is surprising is that for 2-year Trasuries, the expected breakeven inflation is also about the same as for 10-years. The market does not believe a deflation story. It did back at the end of last year.
Second, the systemic risk of financial failure has been abated. he flight to quality along the entire yield curve should see some reversal. We are now seeing assets move from the Treasury market into riskier securities. This adjustment of portfolio risk will lead to falling spreads on corporate bonds and a rise in Treasury yields which is what has happened since the beginning of the year and what Krugman is arguing a a positive.
Offsetting some of the systemic risk story is the longer-term triple-A rating issue. The credit rating of the US is being called into question with rating agencies concerned about the size of US government debt to GDP. This may reach the 100% mark if the the deficit trends are not reversed. We expect that this will have lead to an increase in rate risk premiums; however, the size of the increase is unclear. The impact of lower rating in Japan, for example, is hard to measure albeit probably higher.
Third, the saving glut argument is still relevant but in a state of flux. Krugam argues that the excess savings from around the world will still exceed the supply of new Treasuries. There is no question that there will continue to be a savings glut but the size is declining and other governments are also running deficits.
On the other hand, the savings rate in the US is higher which means that domestic funds can be used to buy up the Treasury debt. The higher US savings rate can also offset some of the decline in demand form foreign buyers. There will be less crowding out all else being equal. Higher deficits can be sustained at a given interest rate. There will also be more savings if there is stimulative effect from an increase in the growth of the economy. US savings can also be used to buy debt that was formerly invested in higher leveraged products and moved to cash. However, it is not clear that the excess savings will be able to clear the Treasury market given the size of the debt being issued over the longer-term.
Crowding out may occur if there is an overall rise in rates which cuts into investment projects. Now if corporate spreads decrease as Treasury rates increase the net effect may be that there little change in the cost of borrowing for corporation. In fact, to some degree this is what is happening. The increase in Treasury debt has not effected the willingness of corporations to issue debt. However, as the debt binge increases the potential for crowding out will increase.
So who is right? Both. This makes the arguments a non-debate; nevertheless, it is the continued increase in debt that on the margin may have a negative impact. The CBO already reported back in February that the impact of the stimulus package would be zero because of crowding out from higher interest rates. Their projections look optimistic relative to where we are currently with the economy, so the impact of crowding out over the next ten years will be even more negative. The argument for higher interest rates from Ferguson based on those number tilts the debate in his favor.
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