A NEW FINANCIAL CRISIS LOOMS / MACLEOD FINANCE

A new financial crisis looms

The hope that in the face of weakening economies interest rates and bond yields will decline is wrong. They are still rising in the Eurozone and Japan, leading to a new wave of financial instability.

ALASDAIR MACLEOD

Over the last ninety years there has been a growing belief held by macroeconomists and investment strategists that interest rates and bond yields are under the control of central bank monetary policies.

It has its origins in the Keynesian-inspired role of governments using deficit spending and interest rates to stimulate economic activity when the private sector suffers a downturn. 

However, this is one of the fundamental errors of macroeconomic beliefs as we are about to find out.

Before then and particularly before interventionist Presidents Hoover and Roosevelt, politicians knew not to interfere in the event of a slump for fear of making it worse. 

They, and currency-issuing central banks had learned that the role of interest rates was to manage the currency, not the economy. 

In those days higher interest rates would prevent a run on gold reserves, allowing credit in the form of gold substitutes to maintain their value both internationally and domestically.

We see evidence that what was true under gold standards still applies to fiat currency relationships today. 

Interest rates are the primary influence on exchange rates. 

In January 2021, as US interest rates rose from the zero bound the dollar’s trade weighted index rose from 90 to 113 while rates in other currencies remained supressed. 

And when they began to reflect the inevitable, the dollar backed off, consolidating in the 100—110 range.

But still, the lessons of the role of interest rates remain ignored by the mainstream. 

Let’s try another approach by posing a question: if credit has a greater risk of losing purchasing power, what should happen to interest rates?

The answer should be obvious: unless rates rise to compensate for the greater risk, then the value of the credit will decline. 

Obvious maybe, but it flies in the face of central bank policy, which persists in using interest rates in attempts to manage economic outcomes.

Only this week we see the true role of interest rates and bond yields being proved yet again. 

The background is one of increasing evidence of a US economy stalling, and expectations of a declining Fed Funds Rate to support the economy gaining momentum. 

At the same time, the new German chancellor proposes to relax borrowing rules to accommodate higher defence spending and to establish an off-budget €500 billion defence fund — proposals together with a further €800 billion promised by Ursula von der Leyen which are already leading to significantly higher eurobond yields. 

The immediate consequences for the euro and the dollar’s TWI are shown below.

The inflationary implications are also reflected in the 10-year German bund yield, which has simply soared:

As the marker for other eurozone bond markets, Germany’s bund yields have driven all the others higher. 

And in the case of France’s, highly exposed Japanese investors will be suffering heavy losses in addition to their losses in their own JGBs:

Round One of the bond market crisis was the unexpected rise in US bond yields between 2020—2022, leading to the failure of some regional banks. 

Round Two is kicking off in the Eurozone and Japan, which is set to create a second banking crisis outside America originating in the Eurozone and Japan.

Returning to the US dollar, these growing bond yield differentials appear to be only just starting to undermine the dollar’s TWI. 

Yet, as I have pointed out in earlier articles, the US private sector’s GDP adjusted for the contribution of the budget deficit is not growing by 4.5% as the Congressional Budget Office expects but is actually contracting by 2% in nominal terms. 

Add in the CBO’s forecast of inflationary debasement at 2.9%, and the private sector is already in a 5% slump. 

And due to Trump’s tariffs, it’s getting even worse for the US economy and those of other nations.

These negative outlooks for the US economy and the dollar are bound to be reflected in higher dollar prices for gold, silver, and the entire commodity complex. 

Why? because the Fed is likely to keep interest rates suppressed in a vain attempt to stave off economic decline.

But it is worse than that. 

A contracting private sector GDP rapidly raises government debt to GDP, and by definition intensifies the debt trap. 

In short, the entire financial system is becoming demonstrably unstable. 

That is the clear message from the last few days.

So, what do you do? 

Get out of risky credit and into the safety of real, legal money which is gold!