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Saturday, November 19, 2016

High interest rate environment is coming!

The spark of this vicious interest rate cycle is caused by the bond market selloff.  Bond price and yield are inversely related to each other because bond pricing formula is based on time value of money concept.

As bond prices decrease, bond yields will increase and vice versa.  Bond yields have been low for quite some time and some bond yields are even in negative territory now.  Consequently, investors are selling bonds to seek better returns or yields and this bond selloff causes yields to fall.  As China is USA largest creditor, China foreign reserves are shrinking because the total value of its USA bonds is declining.  Since foreign reserves make up the backbone of the Renminbi (RMB) strength, RMB devaluation is inevitable as investors will sell RMB because its backbone is weakening.  Thus, RMB has been declining to recent lows.

China is the de facto manufacturing factory of the world and the devaluation of RMB will cause inflation to escalate as China has to buy raw materials with higher prices for production.  In other words, China is going to export inflation to the world.  As inflation reaches the economic threshold levels of many countries, they will start to raise interest rates to contain inflation.  The rises in interest rates will cause bond yields to spike up and depress the bond prices further.

Upon sensing this, China will continue to sell USA bonds to cut its foreign reserve losses with the ensuing outcome of shrinking foreign reserves and more RMB devaluations .  This is the vicious interest rate cycle I am talking about.  Therefore, the foreboding of higher interest rates is real and will be coming soon.

1 comment:

Eric Ho said...

As predicted correctly in this post, higher interest rates and inflations are coming.