Not everyone is convinced that today's surplus of money is here to stay. James W. Paulsen, an economist and chief investment strategist at Minneapolis-based Wells Capital Management, says it's a cyclical phenomenon resulting from the last recession and the Federal Reserve's steps to get the economy going.
Paulsen made his case in a recent interview with BusinessWeek Senior Writer David Henry. Here are edited excerpts from that interview:
Q: So, you don't see a savings glut holding down interest rates for years to come?
A: No, I don't. I keep hearing commentary that there's an excess supply of savings around the world, but I don't see it. I see a lot of evidence of spending going on and a lot of price hikes. If we have such a huge excess supply of savings, why is the housing market going through the roof all around the globe? Why are auto sales still near record highs?
Demand for goods and services in this country has been growing 5% year-over-year for much of the last two years. It's not only here. In Japan, demand just jumped, and Mexico just had a tremendous quarter.
Q: But if demand is really all that strong, why are interest rates so low? Don't those low yields prove there's excess liquidity?
A: Yields go down because of a combination of things, and they're self-correcting. Part of it is market sentiment and expectations. We've had a watershed fall in inflation expectations. The sentiment is that we're going to continue to have very accommodative low rates, accommodative fiscal policies and liquidity. The view is so widespread that we're probably headed the other way.
Q: What forces are at work besides the whims of the market?
A: A lot of the excess liquidity you speak of can be traced to the aggressiveness of U.S. monetary policy. The near-death experience we all had in the early part of the decade resulted in the one of the most aggressive policies of easing by the Fed since the Great Depression. And we still have very low overnight rates, even though they are up.
Q: How does U.S. Fed policy explain low bond yields around the world?
A: The overly aggressive policy is being exported through fixed-exchange rates for currencies. China, Mexico, and some South and Central America countries have also adopted aggressive monetary policies to keep their currencies pegged to the dollar.
The strongest-growing economies in the world are the U.S. and, for the most part, those with fixed exchange-rate regimes. The result is that the globe is awash with liquidity. The weaker economies are in countries that have allowed their currencies to strengthen against the dollar.
Q: Is there any precedent to support your argument?
A: Today is the opposite of what led to the Pacific Rim meltdown in the 1990s. Then extraordinarily tight Fed policy forced the fixed-rate regimes to adopt tight policies that blew apart Asia.
The inverse of that debacle is at work now. You see it everywhere: In good commodity markets, in good Chinese growth, in bond prices continuing to go up. Ultimately, this is going to create inflation around the globe.
Q: Inflation? Really?
A: There's plenty of evidence. It's just that it's coming from such low levels that no one is scared. Raw industrial commodity prices bottomed in January, 2002. They're probably up 65% or more now. Core producer prices bottomed in January, 2003. Core consumer prices bottomed in January, 2004, and wages about the same time.
Q: You said low yields are self-correcting.
A: Inflation dries up excess liquidity. Either that, or you end up in a liquidity trap, like the 1930s when you dumped in more and more liquidity, and nobody spent it. But people are spending.
China is still growing 9%. The Japanese unemployment rate is falling to the lowest level in several years. Factory-utilization rates are now pushing above 80%. The self-correcting mechanism is that investment projects become profitable when yields go down. Some things that didn't work at 5.5% work at 4.5%.
Q: What would bring the bond market to your view?
A: Maybe Europe picks up, and we get a good jobs number and a couple of other reports. Ninety days from now people could be talking again about the economy overheating and the Fed being behind the curve. The 10-year Treasury yield could be back to 4.75%. The bond market is incredibly emotional. It will bore you to death, and then it will kill you. That's the way it moves.
Q: How high do you believe the 10-year yield will go?
A: Eventually, it might hit 6% at the top of this cycle. A year ago there were other people who thought that was possible.
Now the high forecasts are about 5%, and I'm a total outlier. History shows when rates go up, they tend to go up a lot.