Rising Interest Rates and the Carry Trade

Rising 10-year yields have been getting a lot of attention, although the rise hasn't been anything out of the ordinary given the uptrend in yields over the past 4 years:

It's also interesting to note that the yield hit a wall when it reached the same level as Fed Funds (5.25%). In normal times the 10-year yield would be considerably higher than Fed Funds.

However, it has made a big difference for home purchasers with the average 30-year contract rate up to 6.61% from 6.1% 5 weeks earlier. As rates rise, the "affordability" of homes for most buyers declines, adding more downward pressure to home prices. This all puts a greater strain on the consumer driven US economy. As I expect most long term US treasuries will either default or be devalued through inflation to the point that they deserve far higher rates to make up for the risk.

Rising yields also means falling market values for bonds already in the portfolios of carry traders. Fortunately for them, the dollar has also been rising fast enough against the Yen to avoid creating much margin pressure or forced liquidations.

Why yields are rising remains in question. Over the past two weeks custodial holdings of treasuries and agencies haven't increased at their usual rate, leading some to speculate that a lack of foreign buying is behind the rising yields. There have been plenty of statements from monetary officials suggesting they'd be reducing the rate at which they acquire new US treasury debt. This is probably having a small impact on rates, but I'm more inclined to stick with my original observation that primary dealers are the main factor influencing the shape of the yield curve.

The 1 1/2-month-stale data on TIC flows came out today, showing that private foreign investors were net sellers of treasuries, but that's normal in April because of the surge in US tax receipts. Major Foreign Holders TIC data showed that Official accounts also reduced short term treasury bill holdings.

Japanese Money Supply data keeps getting revised upward, suggesting that the carry trade is having a bigger impact than authorities realize. I expect that the Broad Liquidity is actually growing at about a 4-5% rate given the way the Yen has been pushed down in recent months, although it may take the Bank of Japan several more months before they realize this and respond to it:


Commentators have been asking for years what would happen if foreign demand for US debt declined. The answer now appears to be that US debtors would just start borrowing in foreign currencies to fund their needs. In my view this represents another escalation in the extent to which the global economy has become unbalanced. It's hard to imagine another escalation that would go beyond this, but with the versatility of the derivatives markets I won't assume this is the last stage. With the government providing tax free status to Samurai bonds it appears that those in control in Washington realize that expanding the debt pyramid is essential to keeping the game going for now.