The Interest Rate Spike, Since QE2, Explained

Click on chart to enlarge

The above chart via Business Insider shows the recent spike in interest rates. Many economists expected QE2 to result in a drop in rates, the opposite of what is occurring. Here's Daily Finance in early November explaining QE2:

The idea behind this approach is that it pours more money into the banking system, which leads to lower interest rates, which will boost the kind of investment that can in turn start lowering unemployment. "Easier financial conditions will promote economic growth," Bernanke says. Lower mortgage rates will boost housing; lower bond rates will encourage investment; and higher stock prices will boost consumer wealth, which will increase spending and eventually profits to economic growth, Bernanke explains.

Here's Bankrate quoting Fed watcher Ken Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School:

The purpose of QE2 is to lower long-term rates. While lower rates mean good news for borrowers, it is bad news for savers.

So what's behind the interest rate spike and could it have been foreseen?

It clearly could have been seen. Here's what I wrote for the EPJ Daily Alert on October 18, 2010:

It's always tough to call a bottom in a market (or top), but my view is that Bernanke's money printing will back fire and that rates will head higher.

This is what I wrote for the EPJ Daily Alert on early November, 2010, just before the elections:

If the Fed opens monetary spigots after mid-term elections, as expected, this should be highly inflationary for all assets, including: the stock market, gold other commodities (both soft and hard) At some point, interest rates break much higher because of inflation.

This is the time to borrow and lock in rates for as long as possible.

It is NOT the time to hold long-term bonds.

So there you have it, although Fed Chairman Bernanke and economists like Paul Krugman continue to argue: A. that there is no price inflation or B. that the price inflation is limited to commodities and demand caused by BRIC countries, in truth, it is their failure, as Keynesians, to understand the importance of money flows, that causes their failure in understanding the huge price inflation at the capital goods level. The Fed money printing first enters the economy and generally flows to the capital goods sector, e.g. the stock market. Pure and simple, price inflation is roaring in the stock market. This is causing more and more investors to borrow to participate in the market. Margin stock borrowing continues to climb.

Further, other ancillary factors, from the reluctance of China to aggressively buy U.S. Treasury debt to the ever expanding Federal deficit, add to upward pressure on rates. The fall in the desire to hold cash balances also plays a role. During the height of financial/economic crisis many sought the supposed safety of Treasury securities for their funds. This drove down rates. Now, that the this desire to hold rates thaws, as the Bernanke manipulated recovery intensifies, many are moving their funds away from the perceived safety of Treasury securities, thus, resulting in further supply on the market, which translates in even higher rates.

I see nothing in the near future that will change this. In fact, I expect the rate climb to intensify. The thawing of the demand to hold cash will escalate as price inflation expands to more sectors. The price inflation itself will cause more investors and speculators to borrow funds and there is no sense that the government will come anywhere near what is needed to rein in out-of-control spending (especially given that the Social Security Trust Fund is now a net liquidator of Treasury securities.)

Once mainstream Keynesian economists recognize that rates aren't going lower, I fully expect them to be way off on how high rates go. They may project a 50 basis point to 100 basis point increase in rates, but they will be dramatically low.  Long-term rates are going to climb by hundreds of basis points. In fact, I wouldn't be surprised to see rates at double digit levels by the end of 2011.  All key factors right now are pushing interest rates higher, and if Bernanke suddenly stops printing, then rates will go even higher in the immediate future, since the Fed demand for Treasury securities will no longer be there.

Bottom line: Expect much higher rates, and never pay attention to Keynesians.