Some of you, like me, may be pleased to note that the 5-year Canada Government Bond closed at 2.495% earlier this afternoon, an increase of 3.02%.  In fact bond yields have been rising since mid-October, when the second round of quantitative easing (QE2 – No Virginia, that is not a ship) was implemented by the US Fed.  So, hopefully the market is starting to head back to normal, and everyone will benefit.

For many of you who have been following my blog, you may recall I am a contrarian on interest rates.  In my opinion, the current low rates are distorting the market, give rise to volatility and low return expectations (low opportunity costs – wondering why investments by firms have been so lack luster and job creations have been so low).  Apparently, there is also an excess demand on money problem, which has not occurred to me (being an amateur, of course).

Why should we Canadians care about this QE2 business in the US?  Because of the proverbial elephant next door, that’s why!  What happens in the US will happen to us.

I would like to summarize a recent article on the Wall Street Pit titled “Rising yield is a good sign” by David Beckworth (Assistant Professor of Economics) of Texas State:

“A key objective of QE2 is to raise nominal spending.  Given sticky prices and excess economic capacity, this increase in nominal spending would boost the real economy.  Now the way QE2 can raise nominal spending is by raising inflation expectations.  Higher inflation expectations create the incentive for banks, firms, and households sitting on money to start spending them.  In fact, the key problem facing the U.S. economy right now is an excess money demand problem.

While it is true that rising inflation expectations may temporarily lower real interest rates too and thus stimulate interest sensitive spending, this effect is of second-order importance and is only temporary.  The real and lasting reason rising inflation expectations are important is that they address the excess money demand problem.

Many observers miss this important point and its implications for interest rates.

Imagine QE2 is successful in breaking the excess money demand problem and aggregate spending increases.  These developments would imply the following: (1) expected inflation must have picked up at some point and (2) real interest rates would start rising in response to the recovery of the real economy.

In other words, one would expect to start seeing nominal interest rates – the sum of the real interest rate and expected inflation – to start increasing if QE2 is successful.

QE2, then, would not only be a boon to the real economy, but also to savers and folks living on fixed income given the rise in real interest rates.

Now Prof. Beckworth thinks QE2 should have been implemented differently – the Fed should have announced an explicit rules-based nominal target and forcefully commit to maintaining it – and he is concerned that political pressure may prevent it from being effective.

Still, if it does work in its current form then rising yields would be one sign of success…. “

If I have not lost you already, I would recommend that you read his full article: Wall Street Pit.

NB: – This blog is by Leo Lee AMP.  He is a licensed independent mortgage broker in Victoria, British Columbia, Canada.  Leo provides professional advice on real estate financing for residential, commercial and industrial properties.  Leo works for you, not the lenders. He is also an approved mortgage agent for the Tax Deductible Mortgage Plan (TDMP.  His blog and Web site are dedicated to providing the public useful and timely information on mortgages, interest rate, real estate, personal finance, money and the Canadian economy.