Why Interest Rates May Crash Now, But Soar Later

September, 2014

One of the greatest financial oddities today is how so many countries with record debt levels can warrant such low interest rates on their sovereign bonds.  Bond investors are essentially locking in negative returns after today’s taxes and inflation, let alone the risk of greater inflation looming in the future.  Even with historically low U.S. interest rates, it is instructive to look at interest rates around the world.  Germany, Japan, and Switzerland all have 10-year bond rates below 1.0%.  Japan illustrates the most glaring extreme.  Riddled with over a quadrillion yen in debt and facing a massively shrinking population, they have embarked on a reckless economic “Hail Mary” to double their money supply.  Even with all of this, investors are still willing to lend Japan money at a paltry 0.5%!

We’ve long warned that an over-indebted world that is aggressively increasing the money supply risks recessionary conditions (or worse) plus an eventual inflationary shock.  As debt levels mount beyond repayable levels, we believe bonds are massively mispriced.  However, with economic weakness likely to develop before new rounds of stimulus trigger more significant inflation concerns, yields are likely to go down before they go up.  How low could U.S. 10 year treasury rates fall?  With yield-starved investors and the right amount of economic weakness, we see no reason why U.S. yields couldn’t dip to 1.5% or even 1.0% to mirror rates in countries like France and Germany. This would give bondholders a strong return during a period of economic weakness.  Caution is at hand however, as this investment should be viewed as a short-term trade and not a long-term hold.

At some point, the coiled spring of inflation will emerge as desperate stimulus measures, unsustainable spending, and record-high debt levels finally rattle complacent investors.  How high could the 10-year Treasury rise on the other side of this cycle?  If the last inflationary episode is a guide, rates reached 15% rates in 1981.  Investors should think carefully about how to position for weakness now and inflation later.