Stephen Roach turns 180 degrees
I now suspect bond yields will stay low for the foreseeable future
I continue to believe this is ultimately a recipe for disaster.
Stephen Roach May 31, 2005

When I first wrote of an interest rate conundrum in January, little did I know how deeply this concept was about to become ingrained in the heart and soul of central banks and financial markets (see my 18 January dispatch, "The Real Interest Rate Conundrum"). But conundrum it is, as real rates remain at unbelievably low levels at the short and long end alike -- in the US, Europe, Japan, and even emerging markets.

Given my concerns over the US current account deficit, I have long been in the bearish camp with respect to the US bond market outlook. A rethinking is now in order. The likelihood of a China-led slowing of Asia has prompted me to change my view. I now suspect bond yields will stay low for the foreseeable future, and I wouldn't rule out the possibility that they might even drift lower.

What worries me the most in this regard is the coming US current account adjustment. History is devoid of examples where external adjustments are not accompanied by falling currencies and rising real interest rates -- the latter being necessary to compensate the creditors of deficit countries for taking undue currency risks.

I have thought long and hard about this and have now concluded that I may be guilty of having overlooked a critical aspect of the interest rate piece of an external adjustment. In the end, what foreign creditors seek in a current-account adjustment is a relative premium for taking currency risk. The key aspect of this premium is the word "relative."

US interest rates need not rise sharply in the absolute sense in a current-account adjustment. All that is needed is that they remain attractive in comparison to rates elsewhere around the world.

I must confess to being stuck on one key piece of this macro riddle: In my view, real interest rates -- both short and long -- are still far too low for sustainable growth in the global economy and for stable conditions in world financial markets.

Yet central banks -- especially America's -- have been reluctant to lead the charge in normalizing the rate structure. The best we have gotten from the Fed is a policy rate that has gone from negative to zero in real terms over the past year. I continue to believe this is ultimately a recipe for disaster.