Interest Rates have to go up or we have to Print More Money

By Marco Pietropoli, July 2010

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Investment Performance

There is a huge amount of refinancing that needs to take place this year. The amount of Sovereign Debt that is falling due this year is massive. This is before you count the Local Government, Banks and Corporate debt that also need refinancing.

But the yield being offered by governments are amazingly low and the market seems to be content with negative real yields. How can this be? How could a rational investor knowingly chose to lose money on their investments? It would seem illogical.

To give you an idea, if you were to purchase a 2 year Treasury Note (US) the current market yield is just 0.62% pa. But inflation in the US is 2% . So the investor is choosing to have a negative real yield and also risk to capital if interest rates were to rise in the next 2 years and the investor sold before maturity. Interest rates have only one way to go from here.

There is also the risk to capital if the Dollar were to fall. The Dollar is probably overvalued at present due to the weak Euro so this is a real risk.

In the UK the 2 year Gilt Yield is 0.75% pa , but inflation is well above that with CPI running at 3.4% and RPI at 5.1% before we count the recent rise in VAT.

Again it would seem illogical that a rational investor would buy these bonds. Then you realise that it is not investors that have been buying Bonds but it is actually the Central Banks who have been very busy printing money over the last few years.

Since the money printing has been put on pause market interest rates have been rising. Have a look at the recent numbers for the 3 month LIBOR (UK inter-bank rate). Another way of looking at money market tensions is to look at the TED Spread (The TED Spread is the difference between the interest rates on interbank loans and short-term U.S. government debt). This has also been rising recently.

This may all seem very technical and to be honest I can send people to sleep if I talk about bond yields. What does this all mean? Well, if there is more money needed that what is available you have to pay a higher interest rate to attract it. At some point investors will start to demand yields that pay a positive real rate of interest.

Or the other option, which I'm afraid is far more likely in the near term, is more money will be printed. Many leading economists and most Central Banks still feel that inflation is not a problem and the risk of deflation is still real.

It is politically far more acceptable to have high inflation than riots on the streets like Greece has. Also, I firmly believe that every generation thinks that it will be different for them if they print money.

High inflation is what is needed anyway for us to be able to manage our debts as a country moving forwards. The systematic destruction of money will continue for some time to come.

                                                  Medway Independent Financial Advisor