13 June 2007

Interest rates beyond the Fed's control?

A Brave New World

This note (below) from the RGE Monitor email teaser/newletter acknowledges an important point that is often glossed over:

Discussions of US currency depreciation note the relationships between trade balances, deficit spending, global liquidity, bond yields and dollar denominated foreign reserves held by the rest of the world's Central Banks. Yet, discussions of whether or not the Federal Reserve is going to raise target interest rates focus on the US Consumer Price Index or other measures of US inflation / or economic performance making little or no reference to global dynamics.

As global economic growth continues to out perform current US economic weaknesses there will be less and less need for foreign Central Banks to buy weakening US dollars. Global factors may then begin to dominate real US interest rates regardless of US economic performance or internal rates of inflation and regardless of the policies of the Federal Reserve.

Last week, U.S. yields on the 10-year notes shot above 5%. Explanations for the sudden move abound: Bill Gross, mortgage convexity hedging, a shift in Asian demand toward the short-end of the curve, stronger global growth, concerns about rising global inflation and monetary tightening by central banks, capitulation by long-standing U.S. economy bears/bond bulls. Check out “Recasting the Outlook for U.S. Bonds: 10yr Note Exceeds 5%.”

Certainly expectations for stronger U.S. growth and the possibility of a mild acceleration of inflation – still the Fed’s “predominant” concern – played a role. Talk has shifted from a future Fed cut to a persistent Fed pause or even a possible year-end rate hike. But it is also possible that U.S. rates – not just rates in the formerly capital-importing emerging world – are increasingly shaped as much by global as by local developments. Are U.S. long-term yields being pushed up by changing expectations about the U.S., or by stronger growth, rising inflation and expectations of higher rates globally?

(This note originally had several links to more in depth articles, unfortunately they were all within the subscribers only sections of the RGE Monitor site. You'll have to settle for the teaser...)

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