US Rates to Go Lower

Feedback/correction from yesterday’s blog: When I presented the interest rates and the inflation rates of various countries yesterday, I apparently made a mistake on the yields of Brazil government debt. I mistakenly presented their 10 year rate on dollar denominated debt, and not on the debt of the real, Brazil’s local currency. Instead of the rate being 3.75%, their 10 year borrowing costs is 12.05%, for a real rate at an eye-popping 7.35%. (A reader pointed this out to me). This clearly does not fit in with the picture of real interest rates in the BRICs being clearly negative. So I did a little bit of research to discern what is going on with Brazil, and it turns out that Brazil experienced astronomical inflation in the 1990s. To put it in perspective, inflation peaked at 6800% in 1990, and again at 4900% in 1994. Assuming an average peak of 6000%, that amounts to a monthly increase of 500%, or a 5 times increase on a monthly basis. Just imagine a loaf of bread going from $1 one month, to $5 the next month, and $15,000 6 months later. That is a stupid amount of inflation, and the legacy of these events still hangs over Brazil. Accordingly, the market is demanding a real rate of return of 7%. Given this backdrop, I consider Brazil to be a special situation.


* Along the lines which I presented in blogs this week, a reader writes in with a rather interesting analysis which supports the idea that US rates and inflation will remain low for a very long time. One of the conclusions I drew in yesterday’s blog is:


In order for the US to engender an investor philosophy of investing for inflation, long term (10 year) interest rates need to drop to zero.


A reader writes in with the following logic, in support of this conclusion, but from a different perspectives. It’s a bit complicated, so I’ve embellish some of the reader’s points in parenthesis:


“If you (look at bloomberg’s interpretation of the Taylor rule, which bloomberg users can observe by entering TAYL on your bloomberg terminal), we might begin to get an idea of amount of QE necessary to drive price changes in the US economy”.


Rick’s two cents: A complete description of the Taylor rule can be found online at:

LINK`http`en.wikipedia.org/wiki/Taylor_rule`line-height: 1.2em; text-decoration: underline; color: rgb(0, 51, 153); outline-style: none; outline-width: initial; outline-color: initial; `LINK 


To summarize for those who want the simple answer (excerpted from the link), the “Taylor rule is a monetary-policy rule that stipulates how much the central bank would or should change the nominal interest rate in response to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP. The rule is intended to foster price stability and full employment systematically by reducing uncertainty and by increasing the credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy”


According to the Bloomberg analysis, the Fed would need to lower interest rates by 150 bps, which presents a problem, since short term interest rates are already at zero. The reader’s comment continues:


“Obviously, they can’t lower the funds rate, so apply the rule Dudley announced in his peach – $500B of QE  = 50 to 75 bps of easing. To be as accommodative as in past recessions, the Fed needs to overshoot neutral by about 150 to 200 bps. This would imply additional QE of 2.5 to 4 TRILLION!                                                                                             

The reason that I point this out, in response to your blog, is that the actions of the mercantilist export nations drive an interesting feedback loop. The rational reaction to a debasement of the US dollar should be for nations sell their dollar reserves to preserve the economic rent they have extracted by running many years of surplus. Instead, what do they do? They buy more dollar assets in order to offset the FX movement driven by the Fed’s money printing. The Fed has not done anything yet and we have seen 20+ interventions. Why is this a feedback loop? Well, let’s assume the Fed announces 1T or QE at the 11/3 meeting and since that is above market consensus rates rally and the dollar tanks versus floating exchange rates. Now assume that in response that Japan and China increase the USD asset purchases to offset the FX effect.(China will do this automatically).  What happens? US rates go lower and the dollar rebounds and the US inflation rate remains the same as does the US trade deficit and most likely US employment. So 6 months later when, when nothing changes the Fed does another 1T in QE…. and again, nothing changes. The only outcome is that US rates continue to fall. So we can we see extremely low levels of term interest rates and very low inflation in the US. If our trading partners are not willing to let the dollar decline modestly over time, then US rates must move much lower.”


(My comment is welcome to the great depression 2, not your garden variety 1930s style depression, is it? We can thank Helicopter Ben for these new twists and turns). The reader’s comments continue:


“I guess what I find most fascinating about all of this is:  If it happens the way I outline below, the US gets extremely low capital costs and a structurally overvalued currency – so we can buy more imported stuff and finance it at extremely low rates. If all goes well, credit expansion begins to take hold and the US economy “recovers” only to survive until the next crisis, because the root cause, the structural imbalance, was not solved. What I find amazing is that the US can’t solve the structural imbalance because it is driven by the irrational actions our trading partners. They have structural financial repression via negative real rates as well as structurally undervalued currencies that are maintained via holding “reserves” – all for what? China’s central bank is accumulating something that the US can create at will: dollars. In exchange they give us real goods. I am not sure what we are complaining about when we talk about the RMB value is unfair. Its most unfair to the working man in China  – he is being deprived of fair compensation for his labor by his own government. We, the US are getting something for nothing”. (end of readers comments)


Thank you very much for that. This reader’s comment reinforces the point  that US interest rates are going to remain low for a long time to come. Of course, this is exactly opposite what deficit alarmists are worried about. Remember the 30 year graph of 10 year treasury rates which I have presented numerous times, (see the third graph on the attachment on the Sep 28th blog). As it is easy to see, long term interest rates are in a three decade bull market pointing to lower rates ahead. While I have been very vocal about concerns about the our budget deficits, there are factors of epic proportions which have the ability to delay a collapse, due to concerns about the US’s cumulative fiscal deficit.


* News from the Euro-zone – over the last few days, we woke up to videos of riots in France, protesting the fact that their retirement age will be raised to 62. I did not catch what the retirement age was to begin with, but that sounds ridiculous that they are protesting that. Just wait until it is raised to 65 or 70, as it is in the US.


And yesterday, England announced new budget cuts, and the elimination of 500,000 government jobs over the next few years. In addition to this, they are planning on total budget cuts equal to $128 billion. The press releases heralded this as a dramatic round of cuts, equal to 4.5% of GDP. Except for the fact that these cuts will occur over a 4 year period, with an annual savings of 1.1% a year, so these cuts are not so dramatic.


Nonetheless, as the euro-zone phases into austerity, expect to see more protests and demonstrations from over there. Meanwhile, the US is being given a free ride, although, eventually, somehow, we will have to pay back our debts. That will happen when our trading partners wake up to the idea that the trillions of dollars they hold is being devalued faster than they can earn back the difference in trade.