Cat Among The Pigeons

Rising interest rates have thrown the cat among the pigeons.

Global markets are in flux as they weigh the likelihood and the implications of an end to the interest rate cycle.

I think this is classic market "crisis" following the pattern from the last few summers. Equity markets had been on a tear and needed a timeout and it was only a matter of time before the market latched onto something to justify it.

Abe gave them reason to worry and Bernanke caught them by surprise.

I don't think CBs have abandoned the QE formula and will provide confirmation of that if the markets continue a more sizeable pullback, ie. 12%.

Now at some point in the future rising rates are going to be a real issue, but I think current palpatations are a little premature. With the 10 yr pulling back from 2.3% we might have seen the high in interest rates for at least the next 6-12 months.

The Most Critical Thing

Future prosperity and expansion are entirely dependent upon the ability of the central banks to keep the interest rate genie in the bottle.

I don't know how they have done it so far. But the potential effect of a normalization of interest rates would be massively deleterious.

The treasury market implies long term inflation of about 2%. Assuming a 3% term premium, then normalization would return rates to between 4%-5%.

The debt servicing burden would very quickly rise to an unsustainable level - 15% of the government budget and 12%-15% of personal income. Lock it in while the going is good.

Why are bond yields so low?

There are myriad reasons why bond yields are so low. I have found it useful to list them so that I have a framework for seeing the various parts and gauging how they change over time. Here is why bond yields are so low:

(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.

A tough circle to square

Is global infrastructure an asset class? Don't know, don't care.

It doesn't matter. What matters is that there are great hopes and great needs to build out and support infrastructure (water, power, transportation) around the world over the next 20-30 years. I saw in one place that they estimated global infrastructure spending at around $35 trillion over the next 20 years. Even if it is half that amount (which is probably more likely), it is a substantial amount of money.

Quite apart from the obvious need and the potential investment opportunity, the case for global infrastructure development begs the question. Who is going to sponsor the development? Where are the funds going to come from to pay for it? and, What will be the cost of those funds?

Infrastructure sponsorship is generally the domain of government. But governments the world over are going to be balance sheet and budget constrained as they pay out on the accumulated obligations of the past while trying to meet the generous promises of the future. Consumers (at least developed country consumers) will be going through their own weight loss program, but at least in cutting back they are likely to be saving a little more and so provide a source of funds (although it will be constrained because they are going to be tapped out by higher taxes to pay for everything and higher costs associated with paying for the new/improved services - not much discretionary spending in the future). Finally, corporations. They are going to be only too happy to provide the product/services to develop infrastructure, but don't have the independent financial capacity to borrow sufficiently to fund projects. A conundrum.

When demand is greater than supply, prices go up. With government needs for funding set to rise, massive global works projects waiting in the wings, it only makes sense that the price of money goes up.