Treasury Yields Up, Re-Inflation Right?
Treasury Yields Up, Re-Inflation Right?
How this will all unravel
The recent jump in Treasury yields has sparked widespread concern. There are plenty of narratives being formed around this. Could this lead to a U.S. debt crisis, or perhaps a return to the high inflation rates of the 70s?
So, what's really happening?
Government Debt
We have been predicting a US debt crisis since the 80s. The key question is whether we have reached the limit of what the markets will tolerate. One relationship that can offer insight is the US Treasury rates vs the German bond market.
Historically, US Treasury rates and German rates have often moved in tandem, almost as if they were a single market. The pattern of convergence and divergence between the US and German markets is not a recent phenomenon. It can be traced back to 2008 and 2009, with notable examples in 2010 to 2012. This pattern began to change around December 2022 with continued divergence in 2023. US Treasuries started to outperform their German counterparts, with yields lower in the US market relative to Germany.
In 2017 and 2018, the divergence between the German market and the U.S. was largely due to uncertainty about the Federal Reserve's actions. Once the Fed stopped hiking rates, the markets converged again, providing insight into current economic conditions.
In late 2022 and early 2023, a similar divergence occurred due to uncertainty about Fed rate hikes. The U.S. bank crisis hit regional banks hard, leading to increased uncertainty and potentially an end to rate hikes. This divergence could also be explained by difference of short term rates set by the European Central Bank (ECB and the Federal Reserve. The ECB paused in September and the Fed has had discussion about higher rates for longer.
Based on the above history, we should see US rates converge with the ECB. Even with talk of higher rates for longer in the US and Fed rate cuts reduced to 3 expected for the year, the US is not in a position to where rates could go further. It should also be noted when we zoom out US10y rates have been in range of 4% to 5%, with peak rates happening in 2023. We would expect rates to peak with inflation hit peak of 2022. The fact that rates dropped from 5% back down to 4% should further confirm we are trading in a range and that every increase upward in rates does not mean we are moving towards reinflation.
Asset Prices Restrict Interest Rates
Higher interest rates would really shake things up, destroying much of the wealth of the older generations. If it becomes more expensive to borrow money, fewer people can afford to purchase many assets (housing, cars, etc). This means prices would likely have to drop to attract buyers or we would face severely illiquid asset markets. We're already seeing hints of this, where housing markets are getting stuck because no one is buying at current rates. As well, we are seeing deflation in the car market as used card prices are freefalling due to interest rates being higher. As borrowing costs go up, fewer people can buy, which inevitably leads to falling prices. So, if interest rates keep climbing, we could see more of these trends, with big impacts on anyone trying to sell their assets.
Now one thing that could offset this is government intervention. If the government begins giving out stimulus checks or universal basic income then rates in theory could push higher. This is how things could play out long term, but probably not short term.
1970s Strikes Again - Reinflation
This is quite a popular take on twitter, that the current interest rate environment is similar to the interest rate environment of the 70s (chart above). There are some key differences between this time period and the 70s. Demographically we are in contraction while in the 70s we were in expansion. Additionally, during the 1970s, the U.S. abandoned the gold standard due to pressures from an expanding dollar network, which the then-existing gold standard could not sustain.
This significant shift occurred when the U.S. decoupled the dollar from gold, leading to a surge in both gold prices and interest rates due to an oversupply of dollars. As well, if we were to see reinflation we would need to see the money supply increasing. If the money supply remains stagnant, any burst of inflation will eventually lead to disinflation or deflation. We would expect M2 to be increasing, not stagnating (as we see below).
Government Debt fueled Inflation
With the U.S. governments continued spending and the continued expansion of the Feds balance sheet, it is easy to make comparisons between economies that have experience hyperinflation/high interest rates like Argentina. There are a couple key distinctions of why US has not spiraled into hyperinflation.
One, the us treasury market is vital for the operation of the US dollar system and the Eurodollar market. Next, the Argentina Bond market does not have the depth and track record of the US bond market. There is a much higher confidence that the US will not default on their debts, aka go bust.
As well, demand for U.S. Treasuries is not just about investing or dollar liquidity, their is demand to own safe and liquid investments. As for those that tout how the demand for US treasuries is dwindling, take a look at the rehypothecation of US treasuries. This practice would not exist if demand for US treasuries were low. (Rehypothecation is the practice where banks, brokers, or individuals use collateral that they do not own) So banks will basically borrow these treasuries from another institution, instead of buying them outright.
While the US debt is not infinitely sustainable and history shows that countries with the reserve currency eventually lose it, the current environment does not have a viable competitor. There are systems proposed like a gold back currency or bitcoin, but these systems have not reached a network size to even compete with the US dollar. These stores of values must move into a space where they can be easily transacted on a day to day basis. Basically until it is possible to only use these assets to live day to day, the network is not yet strong enough to support a reserve currency.
Thanks For Reading!
This is a complex topic. For a deeper understanding, we recommend checking out eurodollar.university (link). They offer extensive insights into this subject.
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