So, the past few weeks have seen the yield curve become much more vertical and is now drawing a lot of attention. Namely, long-term interest rates are rising at a rate that is alarming even the Federal Reserve. The question everyone, including the Fed, is asking is "why?"
It typically indicates that investors expect future economic growth and inflation that comes with it. It means that more risk-averse investors are moving away from the safety of bonds and into stocks instead.
I read John Jansen's blog faithfully as he chronicles the bond market, he gives several explanations.
The big question is: Is the bond market passing verdict on the U.S.' rapid accumulation of debt, expected to be 89% of GDP by 2019?
Nations that run up that much debt tend to monetize it. They have their central banks purchase the debt by creating more money, which depreciates the value of the money. This creates inflation (prices are the measure of the value of a dollar) and reduces the real cost of the debt (the dollars we pay China are now worth less than before). So, investors knowing that will demand much higher interest rates from the government they're lending to in order to not lose out because of the interest payments being paid with dollars worth less.
Daniel Gross of Newsweek sums up the current online (and in print) debate between Niall Ferguson and Paul Krugman. Martin Wolf also summed it up well in the Financial Times this week siding with Krugman (as does Gross). Krugman has argued that there were plenty of excess funds sitting idly by because of the lack of consumption and investment, which means that the government could fiscally stimulate and not drive up interest rates. Ferguson argues that investors are demanding higher interest rates for continuing to loan the government money, that government borrowing is now crowding out domestic investment. Ferguson and others point out that the Fed is now purchasing long-term securities, effectively monetizing the debt.
Martin Wolf points out that the interest rate on TIPS indicate inflation expectations of 1.6%, which isn't bad (simply means we're no long expecting deflation, a serious concern 6 months ago) and that corporate bond spreads have narrowed from last year, meaning investors are less fearful than before and expecting economic growth. So, inflation expectations have not gotten out of hand yet, which is important (Rebecca Wilder). So long as the U.S. economy grows at a good pace, the debt is not something of great concern, so Wolf and others argue it's a good thing that investors are expecting growth.
But this past week Ben Bernanke predicted "below average" growth for the near term. The Fed has already ballooned its balance sheet to over $900 billion, something that has many people thinking eventual inflation, even though the Fed disagrees.
This is hotly debated, with even German Chancellor Angela Merkel getting involved yesterday, railing at central banks' actions. Some speculate that the Fed will respond to inflationary expectations by raising interest rates (Fed funds futures market currently gives a 50% of a rate hike at the end of this year) before the recovery is complete, meaning possible stagflation.
While I understand the argument of Krugman, Gross, and others, I'm starting to wonder:
The biggest long-term threat the government faces is the increase in entitlement spending for Medicare due to retiring Baby Boomers and rising health care costs. Doesn't matter who is president, or really what the deficit is today. The debt is projected to be well beyond 100% of GDP for as long as you want to project the model. And economic growth isn't going to eliminate this problem. Therefore, long-term interest rates SHOULD be higher, MUCH higher than what they are now. Unless everyone expects that we'll fix the Medicare issue and get health care costs reigned in (which there is no real plan for now). As David Beckworth asks: "What is the U.S. Debt-to-GDP number that is too big?" Everyone, including Krugman, knows this is a central issue, but Keynesians tend to focus on the short run.
So, the debate will continue. I guess we'll find out in 10 years or so who was right and whether we're all screwed or not. As we approach "then," look for more people to check the yield curve for some indications.