by Alasdair Macleod, GoldMoney:
This article is about why interest rates and bond yields are rising and why they will continue to rise, threatening to undermine the entire western banking system.
Rising bond yields are deferring the prospect of a central bank pivot away from fighting inflation to tackling a widely expected recession. Anyway, these expectations wrongly assume that price inflation will fall in a recession, leading to lower interest rates.
History tells us that monetary debasement, rising prices and a slump in business activity go together. Indeed, a slump in economic activity is almost certain, but interest rates will continue to rise reflecting declining purchasing powers for fiat currencies. There is nothing the monetary authorities can do to prevent it, and consequently a cyclical banking crisis, this time including both central and commercial banking systems, is bound to result.
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In this article, I point out the consequences of not understanding the true role of interest rates, the fallacies surrounding commodity price formation, and why a general glut cannot happen, which according to the Keynesians drives recessions.
Blaming inflation on Russia or other external forces cuts no ice. Our crisis is entirely of our own making. Rising interest rates are our silent killer.
Introduction
Central banks were happy to suppress interest rates, even into negative territory, so long as the heavily managed consumer price inflation statistic was rising at an annualised rate of two per cent or so. But the expansion of credit during the covid pandemic changed that, with prices subsequently leaping above the two per cent target. The new price trend first became evident in mid-2020 in both producer and consumer prices. And when NATO decided to respond to the Russian invasion of Ukraine a year ago by cutting off this major energy and commodity supplier from global markets, prices soared, and interest rate suppression policies backfired.
The last time the Fed tried to let interest rates “normalise” and quantitative tightening replaced easing was before the covid pandemic. It raised its funds rate to the then dizzy heights of 2.25%–2.5% in mid-2019, leading to a repo crisis that September, and a stock market crash when the S&P 500 Index lost one-third in just five weeks between February and mid-March. QE then returned with a vengeance and the Fed funds rate was pinned to the zero bound for fully two years. And now it stands at 4.25%—5%, double the level which led to the 2020 market crisis, which was in more benign conditions.
The only thing that stands in the way of a new market crash is hope; hope that the inflation dragon is little more than a magical puff of the imagination. Initially, we were told inflation is transient. Then we were told and are still being told that it would definitely return to the 2% target, only it will take a little longer…
It is a story of which the market is now getting tired. After consolidating earlier rises in late-2022, bond yields are rising again, signalling that international investors and speculators are losing the faith. Figure 1 below illustrates the position for dollar bonds.
The generous gap between higher short and lower long-term yields is a measure of investors’ hope that in time interest rates will decline with the rate of inflation. A negative yield curve (positive being the normal condition) is said to foreshadow a forthcoming recession. In Keynesian terms, it indicates that the prospect of a general glut of product arriving on the market and insufficient consumer demand will lead to a decline in prices. It is an argument based on unsound reasoning more than evidential fact, but so long as investors imagine it, they continue to maintain their overall bullishness. For them, normality is consumer price inflation returning to a normal 2%, interest rates falling back towards the zero bound and credit expanding again.
An underlying assumption is that all changes in prices emanate from the supply and demand for goods, and that the purchasing power of the currency is a constant. But when the quantity of a fiat currency and associated credit expands massively and given the vagaries of human evaluation, this cannot be true.
In a ring-fenced economy, where domestic investors are the only players, the Keynesian fairy tale can persist for longer than any objective analysis suggests is reasonable. But major economies are interconnected in multiple ways, and foreign perceptions can and do differ from the domestic. At some point, the foreigners’ patience in a currency with suppressed interest rates and falling purchasing power becomes lost and the currency is sold down, unless the monetary authorities wise up to their errors and raise interest rates sufficiently to protect the currency. And when all major central banks try to protect their currencies from foreign selling by following similar inflationary policies, foreigners tend to do two things. They reduce their exposure to foreign currencies by buying back their own so that they are not exposed to foreign exchange risk, and they buy other things which they may need in future, stockpiling gold and commodities simply to get out of depreciating currencies.
There is no doubt that the currency to which foreigners are most exposed is the dollar. When they turn sellers, it is usually an unpleasant surprise for domestic investors, who have learned to live with statist mismanagement. For foreigners, the wake-up call is most likely to emanate from yet higher interest rates, being signalled by an emerging higher yield trend on the 10-year US Treasury note.
This article examines the factors which set interest rates, as well as the errors driving central bank monetary policies. It then follows up with a brief analysis of the parlous condition of banking systems, and the consequences of their failure.
The truth about interest rate mismanagement
According to official monetary policy, interest rates regulate the demand for credit. But M3, which is the widest measure of currency and bank credit appears to show little or no correlation with swings in interest rates over the entire history of the purely fiat dollar (i.e., following the suspension of Bretton Woods). There might appear to be some correlation following the suppression of rates to the zero bound in early-2020. But an examination of events shows that the increase in M3 was the consequence of accelerated quantitative easing and bank deposits enlarged in a helicopter drop into individuals’ bank accounts. It had little to do with interest rates.
In recent months, the rise in the Fed funds rate has accompanied a contraction in M3, but to a large extent this contraction represents a withdrawal of credit from financial activities, which is not a policy objective. Undoubtedly, banks have become aware of increased lending risk, an awareness which is examined later in this article. But some of the deposits which would otherwise make up the M3 total have been diverted into reverse repos at the Fed by banks lacking balance sheet capacity to take them in, reducing the M3 total from what it would otherwise be by some $2 trillion.
