How high will interest rates go as QE fails and bonds tumble?

Posted on 14 October 2010 with 1 comment from readers

Marc Faber put the cat among the pigeons this week with his forecast that the bond market was nearing an ‘important inflection point’ and that interest rates would be heading higher ‘within three months’. If he is right, and he frequently is, then that is a reversal of the current global financial market up trend.

However, it is very difficult to read where interest rates would go in this process, except to say that they will go up. Nobody knows exactly how or when the bond bubble will be pricked. It seems unlikely that the Chinese will refuse to buy US bonds, although if a trade war errupts and tarrifs are imposed against Chinese goods that might happen then.

Hedge funds

Hedge funds are a less likely candidate to pull the plug. They will go with the cash flow, and many will be decimated in the bond market fall. Remember they work on taking very risky bets with other people’s money and do not pay penalties for getting it wrong.

But actually if you listen to some top hedge fund managers they are saying buy stocks and houses, not bonds. Perhaps then the bond market could suddenly find itself with a lot of bonds for sale and nobody wanting to buy them.

The problem in assessing how high interest rates would go in a bond market crash is that the market then takes over. That is the whole point. The Fed loses control. The obvious parallel is the US housing bubble that sailed ever higher until somebody said the terrible word ’subprime’.

Indeed, the crisis engulfing US foreclosures threatens a return of the subprime crisis. Basically mortgage titles are now in doubt, and that means who owns what is uncertain.

But the first correction will surely be in the US stock market, now nearing recent bullish highs, and that would give the bond market its last lease of life. This final rally should be the bond market top, and with all the buyers in the market that will probably be what finally tips it over.

With the market back in control of interest rates what should we expect? Well, the market will still recognize a depression in the economy. After all commodity and stock prices will already have fallen back in the first major correction to come.

Fair yield?

What would be a fair yield for bond holders in that market? Certainly a lot more than currently on offer courtesy of manipulation by the Fed. Maybe it is best to look at this from the point of view of how far the bond market would fall in a crash.

Are talking 30, 50 or 70-80 per cent? That would send interest rates up by a half or double or treble them. Most Americans have 30 year fixed rate mortgages but the impact on new or floating rate borrowers would be catastrophic.

That is at the individual level. At the corporate level such a hike in the cost of capital would be absolutely ruinous for the commercial real estate sector. Bank balance sheets would be shattered by the falling value of loan collateral and a second banking crisis is an obvious consequence.

Global domino effect

Around the world the impact of a meltdown in the US bond market would be like the end of a game of dominos. Those currencies directly linked to the US dollar would feel the rise in rates most directly. The transatlantic link between the UK and US would be particularly ruinous. The Chinese economic bubble would pop too.

But then if the cost of capital rises in the US the euro zone will find it hard not to follow suit, although euro exporters might enjoy a brief honeymoon as the dollar soared in value. Of course, those euro zone countries with big debts will suffer hugely and could well default on their bonds bringing another banking crisis.

In the end a world will settle from this crisis with interest rates restored to a level compatible with rewarding savers and pensioners, albeit with much lower bond prices, house prices and the stock market probably higher after a very bumpy ride. Then those survivors with capital can buy cheaply and the whole asset price inflation game can start again.

But this is going to be a very rough process, and that is a function of the extremes of borrowing that got into the system in the very long boom. The Fed would like to engineer this as a long, slow recovery process but to do that it will have to beat the market, something nobody has ever managed to achieve in the history of finance.