US Interest Rates Will Continue to Rise

Martin Feldstein

28 August 2013

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CAMBRIDGESix months ago, I wrote that long-term interest rates in the United States would rise, causing bond prices to fall by so much that an investor who owned ten-year Treasury bonds would lose more from the decline in the value of the bond than he would gain from the difference between the bonds’ interest rate and the interest rates on short-term money funds or bank deposits.
That warning has already proved to be correct. The interest rate on ten-year Treasury bonds has risen almost a full percentage point since February, to 2.72%, implying a loss of nearly 10% in the price of the bond.
But what of the future? The recent rise in long-term interest rates is just the beginning of an increase that will punish investors who are seeking extra yield by betting on long-term bonds. Given the current expected inflation rate of 2%, the real rate on ten-year bonds is still less than 1%. Past experience implies that the real rate will rise to at least 2%, taking the total nominal interest rate to more than 4%, even if expected inflation remains at just 2%.
The interest rate on long-term bonds has been kept abnormally low in the past few years by the Federal Reserve’sunconventional monetary policy” of buying massive amounts of Treasury bonds and other long-term assetsso-called quantitative easing (QE) – and promising to keep short-term rates low for a considerable period. Fed Chairman Ben Bernanke’s announcement in May that the Fed would soon start reducing its asset purchases and end QE in 2014 caused long-term interest rates to jump immediately. Although Bernanke’s announcement has focused markets on exactly when this “tapering” will begin and how rapidly it will proceed, these decisions will not affect the increased level of rates a year or two from now.
The promise to keep the overnight interest rate low for an extended period was intended to persuade investors that they could achieve higher returns only by buying long-term securities, which would drive up these securities’ prices and drive down their yields. But the current version of this promisenot to raise the overnight interest rate until the unemployment rate drops below 6.5%no longer implies that short-term rates will remain low for an “extendedperiod.
With the unemployment rate currently at 7.4% – having fallen nearly a full percentage point in the last 12 months markets can anticipate that the 6.5% threshold could be reached in 2014. And the prospect of rising short-term rates means that investors no longer need to hold long-term bonds to achieve a higher return over the next several years.
Although it is difficult to anticipate how high long-term interest rates will eventually rise, the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2%. A higher rate of expected inflation would also cause the total nominal rate to be greater than 5%.
Today’s investors may not recall how much interest rates rose in recent decades. The interest rate on ten-year Treasuries increased from about 4% in the mid-1960’s to 8% in the mid-1970’s and 10% in the mid-1980’s. It was only at the end of the 1970’s that the Fed, under its new chairman, Paul Volcker, tightened monetary policy and caused inflation to fall. But, even after disinflation in the mid-1980’s, long-term interest rates remained relatively high. In 1985, the interest rate on ten-year Treasury bonds was 10%, even though inflation had declined to less than 4%.
The greatest risk to bond holders is that inflation will rise again, pushing up the interest rate on long-term bonds. History shows that rising inflation is eventually followed by higher nominal interest rates. It may therefore be tempting to invest in inflation-indexed bonds, which adjust both principal and interest payments to offset the effects of changes in price growth. But the protection against inflation does not prevent a loss of value if real interest rates rise, depressing the value of the bonds.
The relatively low interest rates on both short-term and long-term bonds are now causing both individual investors and institutional fund managers to assume duration risk and credit-quality risk in the hope of achieving higher returns. That was the same risk strategy that preceded the financial crisis in 2008. Investors need to recognize that reaching for yield could end very badly yet again.
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

28, 2013 5:00 pm
China’s consumers take eagerly to credit

A few years after finishing university, Jack Dai thought he had scored the holy trinity of success for a young Chinese man: a government job, an apartment and a wife. But he had not counted on one additional factor, less visible from the surface, that soon drove a wedge between him and his conception of the good life.

To buy his Shanghai house, Mr Dai, 30, took out a hefty mortgage. Monthly repayments now swallow up half his salary. Plus he has the other expenses of Chinese middle-classdomoverseas holidays, shopping excursions, movies and restaurants.

Mr Dai is hemmed in by debt. Every second month or so, I can’t pay off my credit card bill. I save nothing,” he sighs.

This experience for a young professional, hardly unusual in the west, is a radical departure for China. The older generation, that of Mr Dai’s parents, was famous for its saving prowess. Memories of deprived childhoods in the Maoist era led them to squirrel away most of their earnings even as their fortunes improved alongside China’s fast-growing economy from the 1980s on.

But the young urban Chinese who have entered the workforce over the past decade grew up amid plenty, and their views about saving and spending bear little resemblance to those of their parents. Their willingness to borrow for today and worry about repayment tomorrow is beginning to reshape China’s debt dynamics.

Day 1: Government debt trail
China’s total debt has increased from 130 per cent of economic output in 2008 to 200 per cent today.
Much focus has been on the rise in government debt, but corporations have been borrowing at a much faster pace.
China has more debt than other emerging markets.
And while debt continues to grow, China’s economic output has started to slow.
Day 2: Corporate debt.
Of the three kinds of debt government, corporate and household – the latter is barely on the radar as a risk in China. Household debt is about Rmb15tn ($2.5tn), or a third of gross domestic product, according to RBS. That is roughly half of what the government owes and a quarter of corporate debt.
To enlarge graph click here
Yet this snapshot misses the dramatic changes afoot. The stock of household debt has tripled over the past five years. Average household debt jumped from 30 per cent of disposable income in 2008 to 50 per cent by the end of 2011, according to the Peterson Institute for International Economics. China still has a long way to go to catch up to personal debt levels in the US or Europewhere it exceeds 100 per cent of income – but many Chinese households are making up for lost time.
“My thinking is, if you can get a loan, you should take it,” says Ray Chang, 29, a ship inspector at the port of Shanghai. Money is worth less and less because of inflation, so it makes sense to spend it now and pay it back later.”

Nursing a mochaccino during a break from his Sunday afternoon English class (paid by credit card), the cheerful Mr Chang was sure he had his finances under control. He had only once failed to make his credit card payment on time, after a shopping binge in Hong Kong when he spent Rmb15,000 ($2,450) – more than his monthly salary – on a Longines watch. “A man needs a good watch,” he says.

By far the biggest expenditure for young Chinese is their house, with home ownership seen by many as a prerequisite for marriage. Nearly 90 per cent of Chinese own their own homes, according to a survey by the Southwestern University of Finance and Economics, well above the global average of 63 per cent.
The government has strict rules in place to limit the amount of debt that can be incurred in buying a house. Homebuyers must make at least 30 per cent of their purchase up front in cash to obtain a mortgage, far less risky than the US before the subprime crisis when zero down payment mortgages were widely available.

But it is rare for new professionals in China to stump up so much money on their own. Both Mr Dai and Mr Chang, like many of their peers, relied on their parents for the entirety of their downpayments.

Beyond turning to their elders for deposits or other purchases, Chinese have a growing array of options to borrow cash. Banks are getting into consumer financing; small-loan companies have taken off; online peer-to-peer lending companies are also booming. The central bank says the small-loan sector has now pumped out more than Rmb700bn in credit, a tenfold rise since 2009.

Regulators have so far been tolerant, even encouraging the development of these new lending platforms. It hopes the surge of consumer credit will help wean the Chinese economy off its addiction to investment and make consumption a bigger driver of growth.

“It’s like the wild west,” says Roger Ying, who last year founded Pandai, one of the 200-plus peer-to-peer lending websites established since 2007. These sites let people with surplus funds lend to others who want money, whether to buy a computer or a car, or simply as extra capital. “Consumer financing could become a bubble. People are doing reckless lending.”

Annualised lending rates average roughly 15 per cent in the small-loan sector, more tan twice benchmark bank loan rates. A Stanford graduate, Mr Ying has developed a system that takes a small cut from each deal to create an insurance fund in case a borrower can’t repay a loan. While default rates among small Chinese lenders are still low at just about 1 per cent of their total loan books, they are beginning to creep up.

Disputes over defaults can end up in courts, but the Chinese legal system struggles to enforce judgments. So for particularly tough cases, some lenders are instead turning to collection agencies like the one run by Wang Taifu out of a suburban Shanghai law office. He used to receive one or two enquiries a day from prospective clients; that’s up to five or six now.

With his law degree, rimless glasses and short-sleeve dress shirt, Mr Wang doesn’t look like a heavy. He only employs them. “If you want to collect debt in China, you have to be tough. You’ve got to push people. My speciality is that I do this within the bounds of the law.”

He refuses to divulge his techniques, apart from saying that he typically sends four people to collect cash and, unlike some competitors, does not bundle debtors into a van, drive them to the countryside and douse them in cold water.

Mercifully, very few Chinese have had a collection agency knock on their door. But many are now facing an equally unfamiliar, if slightly less nerve-racking, challenge of slowing economic growth.

Both Mr Dai, the Shanghai bureaucrat, and Mr Chang, the ship inspector, had assumed things could only get better, with wages steadily increasing. But the government froze Mr Dai’s pay, while Mr Chang’s company cut his this year. Across China, white-collar incomes are increasing at their slowest rate since the global financial crisis.

Mr Dai’s response was to quit his government job last month, giving up the stability of a civil service career for a more uncertain but potentially more lucrative future with an insurance company.
Mr Chang is not changing Jobs. In fact, he remains unflappable in his optimism. Having seen his current apartment rise in value, he is thinking about upgrading to a bigger house. The downpayment will once again be beyond his reach and will even stretch his parents’ savings. But he has thought of a solution.
“We can use my parents’ house as collateral for a loan.”

Copyright The Financial Times Limited 2013


Updated August 28, 2013, 6:42 p.m. ET

The U.S. Strike on Emerging Markets

Developing Countries Were Rattled by the Prospect of War in 2002, but the World Has Changed for the Worse Since Then


A looming war in the Middle East, the lingering legacy of a recent U.S. recession, and very low interest rates suggesting the next move must be upward.

Summer 2013, yes, but also summer 2002. For emerging markets, the outlook is darker this time.

Emerging markets have been melting in the summer heat. This week, with the Indian rupee and Turkish lira hitting record lows against the U.S. dollar, the focal point is expected U.S. military action in Syria.
By injecting fear into oil markets, Syria does exacerbate a problema facing several emerging markets: energy costs. Priced in dollars, Brent crude is still 22% below its 2008 peak. But in rupees, for example, it is around 25% above the 2008 high point.

Higher energy import bills widen current-account deficits menacing several emerging markets. Meanwhile, the threat of war encourages foreign investors to withdraw to safe harbors, draining away the portfolio flows required to plug the gap.
The real threats to emerging markets, though, lie not in Damascus but in Washington and at home.
The MSCI Emerging Markets index underwent an initial correction of 12% in the month following U.S. Federal Reserve Chairman Ben Bernanke's indication on May 22 that the central bank could start scaling back its bond buys in September.
Foreign capital that helped plug current-account deficits in several emerging markets is being called home by the prospect of higher rates. Some $23 billion has flowed out of emerging-markets bonds since May 22, not too far short of the $30 billion that had flowed in since mid-2012, according to Barclays. This, in turn, raises local funding costs and stokes inflation via falling exchange rates.
Back in 2002, rumblings of a much bigger U.S.-led war were in the air and the federal-funds target rate, at 1.75%, didn't look like it could go much lower. Emerging stock markets were selling off, centered on worries about South America.
As it turned out, though, the MSCI index bottomed in October of that year. The Fed actually did go lower: The target rate was cut to 1.25% in November and to 1% in June 2003. Despite the Iraq War kicking off in March 2003, emerging markets began a spectacular bull run, quadrupling by October 2007—even as oil prices surged and the Fed pushed the target rate back up to 5.25%.
Despite the echoes with that similarly fevered time a decade or so ago, the world has changed. For one, the commodities boom that boosted large emerging markets such as Russia and Brazil has petered out. Even if oil spikes on Syrian conflict, the experience of recent years indicates this will undermine demand, either by crimping economic growth or accelerating the drive toward greater fuel efficiency or oil substitution.
Beneath this lies a more fundamental change. In 2002, investors could look forward to a five-year period in which emerging markets' economic growth averaged five percentage points more a year than developed markets. Today, looking ahead five years using International Monetary Fund estimates, the gap looks set to have shrunk to 3.5 percentage points.
What has changed is that, following the financial crisis, the developed world's ability to suck in imports from emerging markets, funded by credit, is greatly diminished. Rising U.S. interest rates will serve to keep a lid on that.
Without that tailwind, the structural challenges facing emerging markets are resurfacing, such as India's barriers to investment and Brazil's inadequate investment in infrastructure. The confused policy response to recent pressure on currencies, be it India's imposition of capital controls or Turkey's convoluted interest-rate corridor, heightens the sense that emerging markets are struggling in this new environment.
Barclays points out that while emerging-market sovereign yields fell during the last Fed-tightening cycle, as the next one looms, they have risen by around a percentage point on average already.
Syria adds to the pain, but emerging markets are fighting a different war already.
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

Markets Insight

August 28, 2013 10:30 am
Eurozone is heading for relapse back into crisis
Weaknesses will be exposed as markets test ECB policy
Since mid-2012, the European financial crisis has been in remission, with the symptoms of the underlying disease temporarily suppressed.
A combination of austerity programmes, debt writedowns, the European Central Bank’s commitment to do whatever it takes to preserve the euro, the proposed banking union and the finalisation of the European Stability Mechanism, the primary bailout fund, helped restore relative financial stability.
Interest rates fell in peripheral countries and stock markets rallied, without any recovery in the real economy. As treatment is discontinued or loses efficacy, there is a high probability of a relapse.
Austerity has failed to bring public finances and debt under control. Increases in taxes and cuts in government spending have led to contractions in economic activity, reducing government revenues and increasing welfare payments as unemployment rates increase. Budget deficits persist, if smaller, and debt levels continue to rise.

Pleading exceptional circumstances, many nations have sought and received exemptions. Deficit and debt reduction targets have been deferred, but are still unlikely to be met.
Further writedowns to reduce debt to sustainable levels are difficult as the ESM, the ECB and the International Monetary Fund now directly or indirectly own large amounts of the relevant debt. Losses to these official bodies would ultimately flow through to taxpayers in countries such as Germany, contradicting assurances to German voters that they were not at risk in the bailouts.

Despite the fact that it remains untested, the ECB’s outright monetary transaction programme (OMT), which allows the purchase of unlimited amounts of eurozone debt, has been hailed a success. But it will be politically difficult for countries like Italy and Spain to ask for assistance, knowing that if a future debt restructuring is necessary, domestic taxpayers face a loss on their bank deposits.

Germany and other eurozone members remain opposed to unlimited purchase of sovereign bonds under the OMT. The programme’s legal basis remains uncertain, with the result of the German constitutional court challenge still unknown.
The banking union was intended “to break the vicious circle between banks and sovereigns”. The key elements of any banking union are deposit insurance and a centralised recapitalisation fund.

German opposition means there are no plans for specific additional financial resources for a eurozone-wide deposit insurance scheme or recapitalisation. Germany insists the banking union cannot be responsible for “legacyrisk, that is, problems originating from events before the finalisation of the banking union.

The banking union has become an inadequate single supervisory mechanism for a small number of eurozone banks. The EU has clarified that the goal is now only to “dilute” the link.

The weaknesses of key policies will increasingly be exposed as markets test European governments and the ECB.

First, the lack of economic growth and weakness of the real economy will increase financial pressure on European countries, including stronger countries such as Germany, which are de facto assuming an increasing share of the liabilities and risk.

Second, banking sector problems will continue. European banks may have as much as €1tn in non-performing loans. Bad debts and weak capital positions will create zombie banks, unable or unwilling to supply credit to the economy, restricting any recovery.
Third, crucial structural reform of labour markets and entitlements will be slow, reflecting weak economic activity and the unpopularity of many measures. In addition, the relative stability of the past 12 months has lulled governments into a false sense of security, reducing the urgency of pursuing economic restructuring.

Fourth, political tensions, both national and within the eurozone, are likely to increase.

The pressures will manifest themselves in a number of ways. Weaker countries may require extensions of existing loans, additional assistance or debt writedowns.

Borrowing costs of weak European countries have begun to increase, reflecting factors such as the economic weakness of the borrowers, political stresses, and the potential tapering of the US quantitative easing programme. Doubts about the OMT programme and decreasing flexibility to use national banks and state pension funds to purchase government debt will accelerate the pressure on rates.

For Europe, it is now a case of NWO (no way out), as without strong growth (which is unlikely) its debt problems may prove intractable.

In contrast to 2012, it is not clear that its response will be, to use the ECB’s oft-used words, “adequate” and “enough”.

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Copyright The Financial Times Limited 2013.