The rising long rates - what is the right explanation

There are several explanations for the increase in interest rates over the last few months. All of them make sense, but all have flaws when compared with theory and with past analysis. There has to be a new view or framework to help explain the rate rise or at least provide some breakdown on the source of the rise.

• Increasing US debt /GDP - The average debt/GDP for '60-'07 was 36%; in 2010 the debt/GDP reached 62%. The numbers should hit above 100% before 2020. The key level of 90% debt/GDP has been used by some economists as the threshold where there is a significant drag on growth, (See work by Rogoff and Reinhart). The debt burden is rising, but savings is also increasing in the US. Nevertheless, the size of the rise in debt is unprecedented so past studies on the sensitivity of debt to GDP may not seem relevant. Analysis of other countries which have had deficit problems seem more appropriate and this suggests that there is a higher risk premium in long Treasuries.

• There is an increase in inflationary expectations. Forward rates for 5-year inflation has increased from 2% which was the long-term core inflation target to 2.90%, a 90 bps rise in just a few short months. The increase in longer-term inflation may be key reason for he steepening of the yield curve.

• There has been reduced Treasury demand by foreign buyers. Foreign investors were buying 55% of Treasuries during the fourth quarter of 2008 and have moved to 34% in the most recent numbers. Of course, the strong buying was during the period of flight to the dollar based on safety but the size of the deficit has continued to go up and the demand for safety has passed. Investors are looking to diversify but the link between buying and rate changes is unclear.
  

• The dollar index have declined to pre-crisis levels. There has not be a strong fall in the dollar and recently there has actually been a rally, but there is a greater potential for dollar decline given the continued savings and debt imbalance. Rates will have to go up to attract capital and allow for a stable dollar.