Now US tax cuts backfire as interest rates go up again

The surprise tax deal between President Obama and Congressional Republicans is backfiring as a deal intended to support Wall Street and bond market confidence is having the reverse effect rather like the latest round of quantitative easing QE2: stock prices are weakening and interest rates going up.

Bond vigilantes appear to have crossed the Atlantic from Europe where they are still actively pushing up bond yields in Spain, Portugal and Ireland. Since November 4th the yield on the US 10-year treasury bond is up by 33 per cent from 2.48 to 3.3 per cent.

Higher growth?

The renewal of Bush tax cuts ought to be positive for markets. But analysts say it has reinforced the consensus behind stronger growth for 2011 and 2012; and heightened the concern over deficits, as deficits will go much higher as a result of the deal.

Perhaps then the real reason for higher bond yields is that the huge debt mountain that America has accumulated in recent years is finally reaching a tipping point when the lenders realize that the debt has grown too big to ever be paid back and that the cost of servicing the debt is just going to end up being added to it.

This is the textbook definition of insolvency or bankruptcy. And by pushing up the cost of debt the bond market vigilantes have a self-fulfilling proposition: push up interest rates high enough and any debtor can be made bankrupt.

No bond holder would want a default to occur but this is a market driving interest rates, not a single lender. The Fed too is only a limited participant in this process, albeit an important one with its control over the inter-bank rate. That has given the Fed considerable power to keep rates low over the past two years but it is not an absolute or indefinite power.

For ultimately the cost of money, or interest rates is set by a market assessment of risk. Bond investors are supposed to sell if a nation’s financial health looks bad, thereby forcing policy makers to change direction. High deficits and low borrowing costs create inflation that bond markets punish with higher interest rates.

Inflection point for markets

However, other financial markets seem slow to wake up to what is happening in the bond market. Perhaps they do not believe what they are seeing or think this is a passing fancy and not a highly significant inflection point.

For the logic of higher interest rates is for lower equity and real estate markets. Rising interest rates are a tax on consumers and business. And the first place consumers are feeling the bond market impact is in long-term, fixed rate mortgages, a factor that can only resume the downward pressure on real estate prices.

An orderly switch from bonds to equities is unlikely. The normal pattern is for a big correction in stock markets and then a shift from cash into stocks, not a smooth rotation. Hence the nervousness and volatility in global stocks over the past few weeks.

Commodity prices are also close to a peak if past precedent is any guide. For as interest rates rise the demand for industrial products will fall and consequently raw materials. Even precious metals can get taken down by rising interest rates, although underlying fear of inflation can counter this effect and may overcome it.