Why Interest Rates Will Rise — Japanese Yen Reaches 15-Yr High Versus US Dollar

Yesterday the U.S. Dollar fell to the lowest level in 15 years when compared to the Japanese Yen, closing at 83.3 Yen per U.S. Dollar.

This has both positive and negative ramifications. From a trade perspective, it makes U.S. made goods and real estate less costly to foreigners and foreign-made goods more expensive to U.S. consumers. At some point that means we import less and export more which equates to more jobs in the U.S.—and that is positive.

Bad news is that a continuing U.S. Dollar reduces the global wealth of Americans and will contribute to higher interest rates. As the U.S. continues to run a massive federal deficit, we do so by borrowing money by selling U.S. Treasurys—with the Chinese and Japanese being the largest purchasers.

Now put yourself in the position of a Japanese buyer of a 2-Year Treasury Note in September 2008 when the exchange rate was 103.4 Yen per US Dollar. To buy a $100,000 Treasury Note, the Japanese investor forked over 10.66 million Yen and earned a miniscule 0.96 percent per year (yep—less than 1 percent average in September 2008). Interest was paid every six month and the Treasury Note is now mature. So the Japanese investor received total interest payments of $US1, 920 and now gets their $100,000 investment back. But the Treasury is Dollar denominated and now must be converted back to Yen (assuming the investor wants their money).

The cash flows and exchange rates would be as follows:

So even before considering the time value of money, this investor lost more than 20 percent on their invest (a function of both a declining value of the U.S. Dollar and extremely low interest rates. You kind of wonder if the declining value of the U.S. Dollar is a major component of Japan’s deflation. Perhaps it is.

You also need to question why there is not a renewed run by foreign investors in U.S. real estate. With capitalization rates in the 7 to 10 percent range, U.S. real estate offers an attractive alternative to Treasurys.

Given this abysmal financial return, how long do you think foreign investors will continue to buy U.S. Treasurys at these low rates? Not long I would believe. The Japanese will continue to buy at the rates only if alternative investments are less attractive (and I can’t imagine that there are not a buffet of alternative more attractive than a 20 percent plus loss in two years). They will buy though at higher interest rates—hence my forecast of rising rates.

Is there an opportunity for a strengthening of the U.S. Dollar? Not likely, given the huge Federal deficits we are running. Now in excess of $1 trillion per year and a decade at this level given record deficits points to a further shrinking Dollar. Take a look at following graph showing the Dollar-Yen average annual exchange rate since 1980.

Do I see a strengthening in the U.S. Dollar? Nope. And that’s because I see no shrinking of the Federal deficit in the coming decade. And that’s before we pay for nationalized health or cap and trade. The storm will get worse before it gets better. And real estate returns are starting to look really attractive.

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