January 18, 2004

Traditionally the last two things (dollar falling and bigger deficits) would lead one to think interest rates are going to go up in the future.  To “stabilize” the dollar the Fed would raise rates to attract foreign savings.  This would increase demand for the dollar and stop the dollar’s slide.  The bigger deficits would lead to higher interest rates as the government borrowing crowds out private borrowing and thus the increased demand for funds puts upward pressure on interest rates.  The fear of higher interest rates in the future would explain the steep yield curve. But this is not what is happening.

Greenspan and the Fed don’t seem to be that worried about the dollar’s slide.  Neither for that matter does the Bush Administration.  Monetary policy is certainly not contractionary nor does it appear that Fed will raise interest rates anytime soon.  Plus, the yield on the 10 year government bond has been FALLING not increasing.  Hmmm.

Some argue the “problem” with the traditional analysis might be that these are not “traditionally” times.  That is, we are so used to times of growing inflation; we have difficulty understanding times when inflation is under control.  So, if the Fed is not worried about the falling dollar AND inflation is under control, there is no reason for the Fed to increase the historically low short term interest rates. 

The steepness in the yield curve thus comes from the short end of the yield curve falling while the long term rates have moved more slowly downward…until now.  Over the last several weeks (months actually) we are see the long term rates falling.  (Note:  “long term” is now the 10 year government bond yield not the 30 year bond as it was a decade ago).

Another one of the things putting downward pressure on the 10 year bond is the Japanese have been buying dollars like mad trying to stop the raising yen.  When the Japanese buy dollars they usually bring these dollars into the U.S. government bond market, so this action is also putting downward pressure on the 10-year yield.

Where is all of this headed?  I’m not sure…but might a flat yield curve that hugs the horizontal axis be in our future?  On the other hand, some argue there is an asset bubble brewing in the Treasuries market and when the bubble bursts, interest rates will soar?  So…who is right?

The FTAA would be an expanded NAFTA resulting in a free trade zone from Canada to the tip of South America.  The Bush Administration had hoped for a FTAA agreement starting in 2005.  Led by Brazilian President Luis Ignacio Lula ad Silva many Latin America leaders balked at the idea of an American free trade zone, wishing instead to work toward better economic integration of South America.

One wonders if these things must be mutually exclusive.  Economists who have a special interest in Latin America (including yours truly) have for years argued that greater intra-Latin American trade would be most beneficial (and profitable) for those in Latin America.  All too often firms in Latin America have had “export to the U.S.” as their main objective.  This however often meant that local markets were underserved.

Now finally, out of spite, the tide seems to be turning.  Many, including Lula, are put off by what they see as U.S. indifference toward the region, and are calling for greater Latin American interdependence.  Ultimately this greater Latin American economic integration, if market based, will be beneficial for Latin America.  However it does not have to include the exclusion of the Americans.  The U.S. has a lot of offer Latin America (and visa-a-versa).  So let’s hope Latin American integration is a step in the right direction, not a step toward regional isolationalism.

See you there,

MB