In late April the yield on the US 10-year Treasury bond broke 3% for the first time in more than four years. Back then it was the fear of the consequences of the unwind of quantitative easing that prompted an aggressive sell-off in bonds in what became known as the Taper Tantrum. Now, a hawkish Federal Reserve already engaging in QE unwind, concern about rising inflation, higher oil prices and an apparent global recovery has conspired to create an unfavourable environment for fixed income. Some think the breach of the 3% level could be the start of a major sell-off in global bond markets. But higher yields are unlikely to last. In fact, when the next crisis hits we may see new lows as central banks resumes their ultimately futile battle against the business cycle.
As the Fed continues its unwind of QE measures, now running at $30bn a month, the pressure on yields is of course in an upwards direction. But as the unwind gathers pace (it’s supposed to hit $50bn a month by Q4), and the Fed continues its tightening cycle (rates were raised again in March and the Fed forecasts two more hikes in 2018), effects will be felt outside the bond markets. Other asset markets that have benefitted from QE, above all equity markets and housing, will start to suffer as yields rise; equities through discounted cash flow analysis and housing through higher mortgage rates. And that is just the start. The much vaunted wealth effect, the confidence boost provided by higher asset prices, will start to dissipate. Higher borrowing costs will hit corporate earnings. Auto and consumer loans, student and credit card debt will suffer. And a Federal government running historically large deficits will be issuing unprecedented amounts of new debt into a falling market. The CBO (Congressional Budget Office) forecasts the US Federal deficit to exceed $1tn in 2020, even assuming healthy economic growth.
In other words, the chickens are coming home to roost. The false idea that the ills of a sick economy can be cured by the morphine of money printing will be exposed. The alchemists in the central bank have not been printing wealth, only papering over the problems, and have stood in the way of attempts to address the capital misallocation that caused the Great Recession. When the next crisis comes, whether a recession or just an aggressive stock market rout, the response will be more of the same medicine. Rates will be cut, but this time from already low levels. QE3 will be followed by QE4 and the Fed could be forced to admit that this time there will be no unwind.
The US economy normally experiences a recession every six years but a decade after the last, few are talking about the next one. But Austrian business cycle theory tells us how recession is inevitable when artificially low interest rates encourage entrepreneurs to engage in the wrong activities and produce to meet the wrong intertemporal demand. Years of monetary policy largesse has now stored up even more problems for the future.
Every recession needs a trigger. After a decade on monetary life support, higher yields could tip the economy into the abyss.