Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?
April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.
Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier.
So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.
You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.
So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.
I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.
Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.
I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.
This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.