The consensus is almost always wrong, which is why today’s conventional wisdom that interest rates will drift higher merits examination.
If the consensus is wrong this time, too, it means one of two things:
- Interest rates will scream higher, clobbering adjustable-rate debtors and killing the economy.
- Interest rates will continue to drift lower, as deflation takes hold.
We continue to believe we’ll get hyper-inflation at some point (option 1), because we think the Fed will be more worried about killing the recovery than controlling inflation and will therefore err on the side of the former.
That said, right now, the prevailing trend clearly is deflation. And as Japan has showed, the spate of deflation before the hyper-inflation takes hold can last a while.
Why deflation? Despite the sequential uptick in house prices in the past few months, we still don’t think we’ve seen the bottom. The banks are still facing huge losses in commercial real estate, which means they’re likely to keep hoarding their capital and not inject new loans into the economy. This should restrain the growth of the money supply. Consumers are starting to save and retiring debt, which should rein in their spending (and, consequently, trigger price declines to try to entice them). We still have huge slack in our manufacturing industries–capacity utilization is very low.
All of which is to say… We wouldn’t be surprised if the obvious trade here–interest rates will drift higher as the economy recovers–is wrong.
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