US 10-year interest rates remain key to the outlook as the benchmark for world markets and consumer demand. And as the chart shows, they are now breaking out of their 40-year downtrend on the upside. In turn, they are supporting the US$ – and adding to the downside pressure on the stock/housing market bubbles created by 2 decades of central bank stimulus.
The issue is that the world is once again grappling with high and rising inflation, caused by an external energy shock. In the 1970s/80s, it was OPEC’s quotas on oil output. Today, it is the natural gas shortage allied to OPEC+ quotas.
So although most commentators continue to assume inflation will soon retreat, history suggests the opposite outcome is more likely.
In turn, this highlights the need to think through second and third-order impacts, as the “virtuous circle” created by stimulus starts to turn “vicious:
- Central Banks have finally been forced by the invasion to abandon stimulus: the ‘Fed put’ is a thing of the past, as discussed last week
- Rates will be “higher for longer” as central banks normalise their balance sheets and reverse stimulus policies
- Recession seems inevitable. This will hit corporate earnings and pressure equity markets – especially those companies with high debt loads
These issues are already having a ripple impact in the wider landscape, to the “surprise” of many players:
- Food price inflation is one example – it has risen every month since May 2021 in the US, and was 11.4% in August
- The issue is today’s higher prices for natural gas, and its reduced availability, as a result of Russia’s invasion
- As the chart confirms, 70% of Europe’s fertilizer capacity is shut down, and this will have a major impact as we move into the new farming season
- And at the same time, of course, the ‘wealth effect’ from the asset bubbles in equities/housing created by 20 years of cheap money are also disappearing
In the longer term, this will accelerate the process whereby markets rediscover their key role of price discovery, in both developed and emerging markets.
But this is likely to be a bumpy “two steps forward, one step back” type of process. As we are already seeing, political pressures are starting to play an important role. These will create sudden and unexpected swings in impacted sectors:
- Japan’s attempt to cap interest rates by devaluing is one example
- The UK’s proposed “dash for growth” via tax cuts is another as the IMF has warned
Unfortunately, history tells us that such desperate measures are doomed to failure.
The reason is that when things get desperate, it is essential to tackle the real causes of the problem. In this case, its the very worrying rise in inflation.
Breaking out of a 40-year downtrend doesn’t happen every day. When it happens, the next moves are usually very sharp and very violent – as we are now seeing with the 10-year rate now rising very quickly. How high could it go?
US inflation was last at 8.3% in January 1982. And then, the 10-year yield was 14.6%, as the chart confirms. History may not be a perfect guide, but it is usually the best that we have. So it might be worth planning for rates to go much higher than most “experts” expect, now that they have broken out of their downtrend.