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Beneath the Surface, Part II: Bonds and Interest Rates   (November 28, 2006)


Yesterday we looked at the downtrend in the dollar. Now let's consider the twins: U.S. bonds and interest rates. As long-suffering readers know, I never tire of repeating that the bond market, not the Fed, sets interest and mortgage rates.

The consensus which has been propelling the stock market for months is that the Fed will lower Fed Funds Rates, and thereby lower mortgage and interest rates. Nice, but forces are at work which could force the Fed to do the opposite, i.e. raise rates.

And why are we considering such an outlandish idea? Take a look at this chart of Treasuries:



What this chart suggests is a breakdown has occurred--put simply, interest rates aren't dropping, they're set to rise further. What forces could cause such a reversal?

Inflation. Again, the consensus is deflationary: the slowing U.S. economy will cause everything to become cheaper. I have attempted to explain here many times that not all forces in the global economy are deflationary. Here is a quick summary:

1. If the dollar drops, imports cost more. That is inflationary. Given that imports are fully 7% of the U.S. GDP, rising import costs are non-trivial.

2. Many costs continue to rise regardless of "deflation:" medical costs, tuition, food, etc. While travel to India for heart surgery is being touted as a solution, it is an extremely small piece of a multi-trillion dollar cost machine. In the meantime, healthcare costs continue climbing. Ditto for tuition, food, water, government services, etc. These essentials are simply costing more on a fundamental basis. Hence my suggestion that deflation is limited to discretionary spending like restaurant meals, while non-discretionary costs such as food, education, healthcare, water and government services are all continuing to rise.

3. Labor costs continue to skyrocket. While outsourcing is continually touted as the deflationary trend which will slay high labor costs, the examples given are trivial in the extreme: yuppies can now hire online tutors based in India for their kids. Nice, but please compare those private savings with the hundreds of billions in local school district budgets, and note the fierce resistance which public unions will offer to "deflationary" proposals such as online tutoring via the Internet.

4. Full employment eventually raises labor costs. In case you haven't noticed, the economy is basically at full employment. Sure, many of the jobs are not great, many are low-paying, and many professionals are under-employed. But to someone who remembers the 15% unemployment of 1981, well, this is as close to full employment as reality can manage.

Lest you believe that rising labor costs are mere figments of imagination, please read this recent piece from BusinessWeek: U.S.: Strong Labor Markets Put The Fed On The Spot; Weak productivity and rising labor costs could force more rate hikes.

5. The deflationary benefits of moving production to China have run out. Now the cycle of rising prices from China begins. Please read this feature from last week's BusinessWeek: Secrets, Lies, And Sweatshops. If you read the piece carefully, you'll note that the factories are all forced to cheat on labor laws because the wonderful U.S. retail giants are constantly squeezing the factories for ever-lower prices. This trend of ever-cheaper goods from China is over; labor costs are rising in China, too, as I have documented here previously. As profit margins for Chinese manufacturers drop to 5% and under, there are no more savings to be had. The cost of goods from Cbina will begin to rise. The deflationary wonder days are over.

Ask yourself this simple question: what can be made in China that is not already made in China? Autos and aircraft? Undoubtedly, but that is well into the future. In the meantime, virtually everything that can be made in China is made in China. What this means is the deflationary forces of offshoring will diminish. The low-hanging fruit has all been picked, and from here on the benefits of offshoring will be harder to discern and perhaps illusory.

6. The price of oil will not plummet to $20/barrel. Why? Production is falling. As I have documented here repeatedly, the supermassive oil fields which we depend on for the majority of our oil from the Mideast are topping out. The Saudis and Kuwaitis are investing in technologies to wring more oil from these fields, but the easy, cheap stuff is already in decline. A U.S. recession may not depress the price of oil as much as expected. (Please see my "archives" link in the right column for all recent posts on oil/energy.)

These forces are non-trivial, long-term and deeply embedded in the economy. Online tutoring is not going to make them all go away.

Last but not least, as many others have noted, the Treasury may have to raise its bond yield if foreign buyers of Treasuries become reluctant to add to their $1.5 trillion stash of U.S. Treasuries. If you look at the chart of the dollar (yesterday) and the bond chart (today), both suggest that a defense of the dollar is looming. To defend the dollar, the Treasury must raise the yields. Interest and mortgage rates will also rise. As many have noted, this will pressure the housing market rather severely.

Why would the Treasury defend the dollar? As I have noted here repeatedly: because they have no choice. We as a nation are living off the purchases of bonds by foreigners. If they hesitate or falter, the Treasury must raise rates to whatever the market demands. There is no Plan B, and the charts are rather clearly indicating this sobering reality.


For more on this subject and a wide array of other topics, please visit my weblog.

                                                           


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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