Michael Hudson : Why interest rates will soar when oil prices rise

The price rise will cause widening trade deficits for oil-importing countries such as Japan. Its yen already has been weakening steadily, to the point where the U.S. Treasury is intervening to support it.

But as its payments for oil imports rise to reflect the price increases that the world oil shortage has created, Japan must avoid further depreciation of its yen by selling its holdings of U.S. Treasury bills. The Bank of Japan doesn’t need to sell these bills directly. It can simply raise interest rates. This will end the arbitrage opportunities that have led to an enormous “carry trade” as speculators borrow low-priced (0.25%) Japanese yen to buy higher yielding U.S. stocks and bonds.

The traditional carry trade has long been based on simple interest-rate arbitrage: Borrow short at a low interest rate from banks (such as the Bank of Japan, or from U.S. banks under the ZIRP policy) and buy higher-yielding bonds. Little effort is required to make gains from the interest-rate margin “in one’s sleep,” as it were.

But for the last two years the arbitrage has involved the U.S. stock market. The arbitrage is not simply between interest rates – low-cost borrowing to buy stocks yielding higher dividends – but to make asset-price (“finance capital”) gains. This new-era carry trade has been a major factor bidding up the “magnificent 7” Silicon Valley stocks.

But if Japan’s government raises interest rates to attract foreign capital – or more to the point, to cause a repatriation of Japanese capital – then Japanese investors will have an incentive to sell their U.S. stocks (as well as U.S. bonds)

This will obliged the U.S. Treasury to raise interest rates to stabilize its own exchange rate and U.S. bond prices.

The longer the Persian Gulf remains closed as a result of Trump’s Oil War, the more severe the world’s oil prices will rise, the deeper foreign trade deficits will be, and the more foreign governments will respond by raising interest rates to attract foreign (or their own repatriated) capital to cope with the disruption.