US follows Japanese rates higher, stranding US economy?

Some economists say we shouldn’t worry that interest rates have jumped a full percentage point in the last six weeks. They rationalize: while this rise will undoubtedly stifle the booming housing market — the only sector keeping the economy afloat for the last 18 months — rates must be up because the rest of the economy is finally recovering. No worries.

What these guys don’t appreciate is how much the rise in rates may be driven by other forces. First, the federal budget has swung to a massive deficit: the Treasury will need to borrow nearly 1.4 trillion dollars more in the next two years than the last two years. That’s a boatload of bonds, and plentiful supply means lower prices: higher interest rates.

Second, much of the recent jump is driven by massive Japanese dumping of long-term US treasuries. Over the last decade of Japanese depression, Japanese banks have made a habit of borrowing yen at nearly 0% and buying US treasuries.

But the Japanese stock market is up nearly 30% since June. As Japanese ten year bond yields have risen 100% in recent months, from 0.5% to 1%, the yield arbitrage from Japan to the US has become less secure, and a major buyer of treasures becomes a big seller: ergo higher rates.

My bet is that Greenspan is more worried than ever.