Game over for US economy?

published 12 December 2005

To see traders "at their most jittery", one need look no further than the $8trn US bond market, says David Henry in BusinessWeek. The yield on the bench-mark ten-year Treasury bond jumped almost 0.25% on the back of an unexpectedly strong employment report in early April amid other signs of a rapidly strengthening economy, all of which compounded fears of an imminent interest-rate hike in the US. There's more to it than that, says Dailyreckoning.com. Inflation has "shown up like a drunken ex-husband at a wedding party". Consumer prices rose 0.5% in March, implying an annual rate - if March levels persist - of 6%. No wonder the ten-year yield has shot up to 4.4% from a near-record low of 3.65% in the past month.

That means rate rises, and has raised the spectre of a bond market rout akin to that of 1994, says Caroline Baum on Bloomberg.com. Back then, banks, hedge funds and Wall Street dealers had borrowed at low short-term rates, bought higher-yielding Treasuries, and pocketed the difference. When the Fed raised rates from 3% to 6%, this massive "carry trade" rapidly became unprofitable, and traders were "carried out on a stretcher", having all been forced to dump their longer-term bonds because their losing positions had all been financed with borrowed money. Optimists who insist this won't happen again should note that, with rates at 1%, "the Fed is starting from a more accommodative perch than last time", and with inflation growing at the current rate, rates could well have to rise very sharply. Moreover, rampant carry trading has left the market twice as leveraged as in 1994. A sharp rise in long-term rates could spread the jitters "well beyond the bond pits", says Henry: it would "rattle" bank lending and "paralyse borrowers, from corporations to homebuyers".

The current yields rise is bad enough, says Mark Rostenko in The Sovereign Strategist. It may end the rise in mortgage refinancing, "basically the only thing that kept the economy from flipping onto its back these past few years". Indeed, says Dailyreckoning.com: the index of applications to refinance mortgages fell by 30.7% last week. The "world's No. 1 consumers" were already having trouble keeping up with their interest payments, so they are in for a torrid time when the Fed, which has "lured" consumers deeper into debt with "unnaturally low" short-term rates, tightens the screw. This all means "it's game over" for the economy, says Bill Fleckenstein on MSNMoney.com, and for over-inflated stock and real estate markets.