Australian interest rates are driven primarily by global interest rates. Our mortgages are hostage to global forces, but what do these say about the future of Australian interest rates? Like economists, financial market analysts have good commercial reasons to hold different views. The recent fall in global bond yields has provoked clear differences of opinion as to causes and consequences.

Gerard Baker of The Times Online argues that the recent decline in the US dollar, which occurred at a time when further central bank rate increases seemed more likely than they do now, is largely due to foreign exchange traders becoming more nervous about US inflation and its effect on the attractiveness of US assets, rather than a reflection that inflation is under control, as is the apparent belief of the bond traders — “Which would suggest that the currency market’s posse of vigilantes may be more alert to what is going on than their slightly somnolent colleagues in the bond markets.”

The Economist sees the slowing of the US economy as the main reason bond yields are falling: “One thing that is for sure, the American market is likely to be a safer haven for fixed-income investors than Europe or Japan. The Fed is near the peak of the tightening cycle, if it is not there already, but the central banks of the two other regions possibly taking up the reins of global growth are only just hitting their stride.”

A colleague has pointed to a third reason to be bullish about US bonds in particular — in a word “recycling”. China’s booming growth is driven by powerful competitive forces that have raised the prices of commodities, in particular oil. China’s extraordinarily strong current account surplus has to be invested somewhere, and US bonds are an obvious haven of choice. Dear oil has produced strong surpluses in the Middle East also, and they also need to invest in paper assets, including US bonds.

All three factors are combining to create the fall in US bond yields. However, cautious readers will want to think through what happens when the financial imbalances that are creating this boom begin to unwind. The Chinese surplus (CAS)/US deficit (CAD) will not be fixed by current attempts to slow the Chinese economy — indeed, to the extent they succeed, such efforts will increase the Chinese surplus. Only Chinese revaluation (or inflation) will do the job, and this implies US currency depreciation (or US deflation).

Should the adjustment process become disorderly, US interest rates will rise sharply. As a fellow deficit nation, Australia’s would very likely follow suit. Watch the CAS — continued growth should worry us all.

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