One of the more common questions I get in the Ask Cullen section is “what if interest rates rise in the USA?” Of course, that would have broad ramifications on the cost of US government debt, asset prices, the recovery, etc. But you have to keep the sequence of events in order here and ask yourself first, “what will cause rates to rise”? I think Ben Bernanke certainly knows what will cause rates to rise (per his testimony today):
“The economy will get stronger because of good policies, and that in turn will cause rates to rise in a sustainable way. If we were to raise rates prematurely we would kill the recovery and rates would come down, and we would have a long-term situation with very low rates.”
“The best way to get sustainable high returns to savers is to get the economy back to running on all cylinders. It’s somewhat paradoxical, but in some ways the best way to get interest rates up is to not raise them too quickly, because by keeping rates low, now, we can help the economies get stronger, we can create more jobs, we can create more momentum in the economy, that’s the way to get a sustainable higher set of interest rates. Until we can get greater forward momentum, we are not going to get sustainable higher returns.”
“One of the paradoxes is that the best way to get interest rates up is to have low interest rates, because that promotes a stronger growing economy and that causes interest rates to rise. In some ways the fact that interest rates have gone up a bit, and it happens on the real not the inflation side, is actually indicative of a stronger economy, which again suggests that maybe this is having some benefit.”
Interest rates on US government debt are really a function of economic growth. If the economy is weak the Fed will pin short rates to stimulate the economy. As the monopoly supplier of reserves to the banking system the Fed can always set rates at the short end of the curve. Long rates on government debt are largely an extension of short rates so there tends to be a very high correlation between the two.
So, the best way to think about rates is to think about the economy, how the Fed expects the economy to look in the coming years and then look at how traders might attempt to front-run the Fed’s policies. But remember, the Fed can control the yield curve, but it can’t control the economy. It can only nudge the economy by changing some influencing variables. But ultimately, the path to higher rates lies with the economy. And if rates rise it’s going to be a function of better days ahead. So, don’t get too worked up over interest on the national debt or what will happen when interest rates rise because, by then, we’ll likely be talking about ways to cool down the economy….Which is a nice problem to have assuming we’re not cooling down the wrong areas (like asset bubbles caused by programs such as QE)….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.