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Inflation Watch: Fed May Be Forced To Raise Interest Rates

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EDITOR NOTE: The story here is pretty simple and one that’s been long-developing. US debt has been mounting for decades, more than doubling, and now exceeding 100% of GDP. The exertion of pressure this places on the economy is reasonably unsustainable, and it will force the Fed to raise interest rates perhaps sooner than it had planned. And when yields do rise again, experts say the effect on the US economy will be more punishing than before. Unsustainable debt needs a resolution, either by reining in spending or increasing revenue. The government is not a wealth-generating mechanism, and the option of reining in spending seems antithetical to the Biden administration’s agenda. Hence, yesterday’s market plunge in response to Biden’s proposal of doubling the capital gains tax rate for certain segments of American society. The timing may vary, but a crash in real and paper wealth in this country will dovetail one another in a sequence that may be less predictable but whose eventuality is certain. What matters most to regular Americans is whether they’re prepared for it or not with a proper hedge.

The U.S.’s mounting debt load may warrant investors rethinking their expectations for a liftoff from the Federal Reserve’s easy monetary policy.

Bondholders took deep losses this year as yields rose amid worries that the Fed may be forced to raise its policy interest rates earlier than it planned, if the economic recovery resulted in rising inflation.

But Kit Juckes, a London-based strategist at Société Générale warns the U.S.’s indebtedness may mean tighter monetary policy could prove more punishing to the economy, creating a ceiling on how high interest rates can rise.

He noted the share of U.S. non-financial sector debt to GDP had risen to 280% this year from 130% in 1981.

The nonpartisan Congressional Budget Office has also noted that during 2020 the U.S. government debt held by the public rose to 100% of GDP for the first time since the end of the Second World War. 

That rise has been accompanied by a steady decline in inflation-adjusted yields, or real yields, considered a proxy for the true borrowing cost to the U.S. government and an indicator of investors’ expectation for U.S. growth.

The 10-year Treasury note yield BX:TMUBMUSD10Y was at 1.58% on Thursday, but the inflation-adjusted rate was still deeply negative at -0.76% on Wednesday.

If real rates rise again as the Fed pulls back its accommodative monetary policy, the pain threshold to businesses and households could show up earlier than expected.

“Whether the real rate peak this time is higher than the last, or not, it seems to me that any given peak level of real rates would hurt the economy more this time around. And this is where the consensus bearish view of bond markets needs to be questioned,” said Juckes.

His argument that more debt could translate into lower interest rates goes against the theory that so-called bond vigilantes would rebel against a country’s fiscal profligacy and sell their bonds, pushing yields higher.

But a growing camp of investors have suggested more debt can be, in fact, deflationary as more of it is funneled to unproductive uses. That, in turn, could lower the long-term trajectory of interest rates.

Originally posted on Marketwatch

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