Optimism for the U.S. economy is spreading through markets. That improved view is elevating fear of inflation, and pressure on long-term interest rates.
The uplifted mood is stronger than the data, but every economic turn for the better begins this way. The twin surveys by the New York and Philadelphia Federal Reserve banks show modest growth, but both show sustained increases in new orders, employment, and prices paid and received. New claims for unemployment insurance are trending down toward 400,000 weekly, the border between not-so-hot and OK.
The jaw-droppers were in housing. New-home starts fell 4.3 percent in December, sensible, but new permits soared 16.7 percent. Then the National Association of Realtors reported sales of existing homes in December, a 13.8 percent rocket up from November (not seasonally adjusted).
Still 2.2 percent below December ’09, with the $168,800 median price falling from $183,000 in June, but holy smokes … anybody in the business see that jump in sales from your own window?
The 10-year Treasury note, at 3.45 percent today, is near top of its range since mid-December, and mortgages are again pressing up on 5 percent. However, these levels are lower by 0.5 percent than those during similar rosy-outlook intervals in the summer of 2009 and spring 2010, both of which failed.
If economic prospects are brighter today than then, how odd that long-term rates are lower now. Is this partly, possibly, due to the Federal Reserve’s "quantitative easing" (QE1 and QE2) purchases of long-term debt? Alternately, maybe things really are not better than the ’09-’10 bright intervals, and long-term rates, while lower than then, are still too high. Maybe far too high.
The largest player of all in this game, and with a one-track mind: the owners of U.S. Treasurys. Known since the ’80s as the "Bond Vigilantes," they protect themselves the only way that they can: If the U.S. appears to tolerate inflation, the Vigilantes will begin to dump their holdings and tighten in place of an AWOL Fed.
In 1970, U.S. gross domestic product was about $1 trillion (in that year’s dollars), and U.S. Treasury debt only $250 billion. More than half had been borrowed 25 years before to fight World War II; the new 1970 budget-deficit borrowing was trivial.
In today’s dollars, 1970 GDP was about $4 trillion, debt about $1 trillion. Today, GDP is about $15 trillion, debt $9.4 trillion. Debt 63 percent of GDP now vs. 25 percent in ’70, but rather worse: Debt is growing another 8 percent of GDP each year. That is the math that has ceded control of our affairs to our creditors.
Even if there is no general run on the dollar (highly unlikely — no other currency to go to), nor a run on U.S. Treasurys (ditto), the action of the Bond Vigilantes has intercepted recovery here and can continue to.
Our economy is in the grip of asset deflation, real estate of all kinds falling in value and in liquidity below pre-bubble conditions, mortgage debt still in place, and there’s no way out except for prices to begin to rise and liquidity to return.
Low long-term rates are the absolute prerequisite for real estate stabilization and then recovery.
The Fed understands and fears the predicament. At the rollout of QE2, the Fed’s intention to drive down long-term rates was explicit, and buying long-term paper 2.5 times faster than the Treasury sold it "should" have worked.
However, the Bond Vigilantes have more outstanding paper available to sell (inclusive of synthetic hedging devices) than the Fed can buy, and their selling has overwhelmed the Fed.
Bond investors want their interest receipts and ultimate return of principal in "real" dollars, ones worth exactly as much as the dollars initially invested. These hard-money boys (joined by most of the banking world) do not mind deflation a bit — deflation means that they get paid back in dollars worth more than the ones invested in the first place.
Like so many suicidal financial impulses, these hard-money Vigilantes ignore the chance that deflation will ruin the capacity of the debtor to make any payments at all.
There is only one way to take back control: Stop borrowing, or at least reduce it greatly. Then the Bond Vigilantes will return to a customary scramble for yield. Until then, we are vulnerable to serial interception of recovery by the runs up in long rates. As now.