What's up with interest rates?

There has been a lot of volatility in the fixed income markets in the past few months. Here are some highlites, and some great links to check out for further reading:

What happened:
* In May, Treasuries sold off big-time, sending yields on the 10-year soaring. This also caused a 10% loss of principal to bond holders.
* Two heavily-leveraged Bear Stearns hedge funds might be imploding. The possible liquidation of the funds -- both of which own risky debt instruments such as CDO's and subprime mortgages -- could have serious consequences for the entire market.


Where do we stand:
* Yields on Treasuries have risen and the yield curve is no longer inverted.
* If you are a "subprime" borrower, it is much more difficult to get a loan
* Despite all of this, interest rates are still very low on a relative (historical) basis. Money/liquidity is still very plentiful -- as is evidenced by the ongoing M&A/Private Equity boom.

My Take:
With interest rates, I think it's important to think about where they're going, not just where they are now. With strong global growth and inflation, I would bet on higher interest rates in the future. If true, this suggests a pretty strong headwind for economic growth and for stocks in particular.

As much as ever, it seems that China and certain Middle Eastern countries control the fate of the global debt markets. The Chinese government holds more than $600 billion in US Treasuries. Their aggressive buying of short term notes is one good reason why interest rates have been so low, allowing US consumers to live way beyond their means for the last few years. In the short-run, this situation works out great for us -- we are able to import a whole lot of stuff and all we give them in return is dollar bills. Even better, we don't even have to pay them back.... You can be sure that the dollars we use to pay our debts back will be worth a lot less than those we are borrowing now.

The Chinese might be perfectly happy with this arrangement though because it creates stability at home... Now that 1 billion people know that it's possible to get rich and improve their lives, they all badly want to do it. Problem is, with an economy that is still largely manufacturing-based, it's very difficult to create jobs for the 20 million graduates Chinese universities pump out each year. The country needs 10% GDP growth rate to keep things stable.

So what do the above two paragraphs have to do with the fixed income markets/interest rates? A lot, I think. The Chinese (along with other major holders of US debt) have an incredible amount of control over the US economy. Not least of which is US interest rates -- witness the inverted yield curve after no fewer than 6 fed funds rate increases; Starting in 2002 when Greenspan raised interest rates to prevent inflation, long term interest rates have actually declined. So, at least for now (and at least through the Beijing Olympics in 2008), China does not want a destabilized bond market.

Follow these links for some excellent, and non-boring, commentary about recent happenings in the fixed income markets:

*Calculated Risk blog post about a great NYT article
*Two articles by Jubak:
* Deepening Debt Crises hits Close to Home
* Can Bond Market Stand to be Exposed?
*Bill Gross commentary