Why Aren't the Prospects of Higher Rates In the United States Leading to Higher Rates In the United States?

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Friday, 31 January 2014 07:57

The NYT had an article discussing the extent to which political unrest in Thailand might have an impact on its economy. At one point it notes a flight of foreign capital from Thailand and other developing countries which it attributes to the Fed's taper and the "prospect of higher interest rates" in the United States.

The problem with this story is that long-term interest rates have actually been falling in the United States. If investors are fleeing Thailand and other countries because they expect long-term interest rates in the U.S. to rise, then these same investors should be dumping long-term bonds in advance of the interest rate hikes (which would lead to capital losses) thereby causing the rise in interest rates they expect. Instead interest rates on 10-year Treasury bonds have fallen from just over 3.0 percent in late December to under 2.7 percent as of Friday morning.

This suggests an alternative explanation for the flight from developing countries. Most likely it is a simple story of contagion, where investors feel the need to do whatever they see other investors doing. In prior years it was fashionable to unthinkingly put money into developing countries. Now that fashions have shifted the cool thing to do is to pull money out of developing countries. Since investors rarely get in trouble for making the same stupid mistake as everyone else, there is a big incentive to follow fashions in investing.