A fundamental interest rate explanation and forecast

Notwithstanding the recent bond market recovery, the lows marked by US and European government bond yields at the end of 2008/beginning of 2009 are a thing of the past. Yields on 10yr US Treasuries are over 100 basis points, and German bunds 40 basis points higher than at the end of 2008. At first sight this does not appear to be in tune with the real economy. After all, in the first quarter of 2009 most of the major industrialized countries suffered the sharpest drop in overall output since the Second World War, and in the second quarter only some of the production losses were offset, despite growing glimmers of hope. So why this marked rise in yields? Several theories are currently being put forward.

The sharp rise in public debt on the back of expansionary fiscal policy is being funded by the issue of government bonds. An oversupply of government bonds is pushing interest rates up.

At some point, the flooding of banks with liquidity and the Keynesian fiscal policy are going to stoke up inflation. Markets are anticipating this and are demanding a higher inflation component in interest rates.

Rising interest rates are merely a reflection that things are returning to normal. The financial market crisis had bloated demand for government bonds; as risk aversion fades, so too demand for government bonds. Yields return to normal levels again.

The rise in long-term interest rates accompanied by still very low short-term interest rates causes the yield curve to steepen. A steep yield curve serves as a good leading indicator for the economy, as it frequently precedes a robust economic upswing. Rising long-term interest rates are an expression of more upbeat earnings expectations among investors. Provided short-term interest rates remain low, this creates good refinancing conditions.

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