The Land of the Free is starting to look ungovernable. Enough is enough … America enjoys the “exorbitant privilege” of printing the world’s reserve currency. Its government debt is considered a safe haven, which is why Uncle Sam can borrow so much, so cheaply. America will not lose these advantages overnight. But anything that undermines its creditworthiness—as the farce in Washington surely does—risks causing untold damage in the future. It is not just that America would have to pay more to borrow. The repercussions of an American default would be both global and unpredictable. … It would threaten financial markets. Since American Treasuries are very liquid and safe, they are widely used as collateral. They are more than 30% of the collateral that financial institutions such as investment banks use to borrow in the $2 trillion “tri-party repo” market, a source of overnight funding. A default could trigger demands by lenders for more or different collateral; that might cause a financial heart attack like the one prompted by the collapse of Lehman Brothers in 2008. In short, even if Obamacare were as bad as tea-party types say it is (see Lexington), it would still be reckless to use the debt ceiling as a bargaining chip to repeal it, as some Republicans suggest.
From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200 basis points to 60 basis points (Chart 1). The recent move from the monthly low in February has been modest by comparison. Importantly, this powerful 6 percentage point downward move in long-term Treasury rates was nearly identical to the decline in the rate of inflation as measured by the monthly year-over-year change in the Consumer Price Index which moved from just over 6% in 1990 to 0% today. Therefore, it was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields. ... In almost all cases, including the most recent rise, the intermittent change in psychology that drove interest rates higher in the short run, occurred despite weakening inflation. There was, however, always a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place. This is also the case today. ... Presently, four misperceptions have pushed Treasury bond yields to levels that represent significant value for long-term investors. These are:
1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
2. Intensifying cost pressures will lead to higher inflation/yields.
3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
4. The bond market is in a bubble, and like all manias, it will eventually burst.
- Also: Wall Street Journal - Higher Rates Wouldn’t Tame Bubbles Even if Central Banks Tried, IMF Paper Says < 5min
- Also: Financial Times - Technology, inflation and the Federal Reserve < 5min
- Also: CFA Institute - Complexity: The Hidden Cost of Central Bank Actions < 5min
- Also: Financial Times - Shadow banks step into the lending void < 5min