Europe Driving Interest US Rates Higher?

Interest rates, across the board, have actually been spiking since the announcement of the QE2 program on November 3. Not to anyone surprise, the Fed was more or less powerless to lower rates from prevailing levels. I argued that QE2 was really not designed to drive rates down from prevailing levels but merely to “accommodate” the fiscal deficit and prevent a rise in rates that would otherwise occur due to crowding out and other effects.

The bottom line was that the real risk was that interest rates throughout the US economy would rise after the announcement of QE2. Indeed, I believe that the US is currently in a situation anticipated in QE2 May Not Prevent a Rout in US Bond Markets, in which I asked: “How much panic would it create if quantitative easing (QE2) is announced, the Fed starts purchasing Treasuries, and bond yields actually start to rise?”

10-Year US Treasury yields (TNX) have risen almost 60 basis points since the announcement of QE2, municipal bond yields have spiked, corporate bond yields have risen, and mortgage rates have spiked. Indeed, overall, interest rates across the board are actually higher than they were before financial markets began to discount the prospect of QE2.

Having said that, it's important to note that although rates have risen, they are still well below levels that could jeopardize the economic recovery. The question is what happens next.

In the short term, a few issues need to be monitored. For starters, investors should be aware of the fact that the crisis in Europe is actually “bailing out” the US in some sense. In the global competition for capital, troubles in Europe make the US seem like a relative safe haven thereby facilitating the financing of the US fiscal deficit. Furthermore, troubles in Europe will tend to depress global growth expectations and ease fears of commodity-driven inflation. Thus, the situation in Europe will be a key driver in US interest rate dynamics.

Second, any whiff of accelerating inflation in the US could have a dramatic impact on the bond markets. Again, developments in global commodities markets are key in this regard.

Finally, at some point, investor scrutiny is going to be turned toward congressional and presidential action with respect to the US fiscal deficit and sovereign debt fundamentals. Today’s news of the failure of the presidential deficit commission to garner the necessary votes to issue an official recommendation is a worrisome development in this regard.

Conclusion

US interest rates are supposed to be falling, not rising. At least that's what we were led to believe a few months ago when market consensus was excited about QE2 and the Fed’s power to stimulate the economy.

It's now becoming clear what I had been emphasizing prior to the implementation of QE2: The Fed is not really in control of US interest rates.

This sense that the Fed has lost control of interest rate dynamics could add an important element of uncertainty into financial markets in the coming months.

This is particularly important in a context in which investors generally are over-exposed to bonds.

A long bear market in US bonds has probably already begun. Bad news out of Europe is probably the only factor that will be able to sporadically arrest the upward assent of US interest rates in the coming weeks and months.

I believe that US bond rallies due to instability in Europe should be utilized to initiate short positions in various categories of US bonds.