Hamish McRae: Government deficits must be paid for in the end - with higher interest rates

Welcome to the world of the big borrowers. So John Snow, the US Treasury Secretary, is at last admitting what we have all known for a year at least: that the federal deficit has become a serious issue. In round numbers it looks like being about 4 per cent of GDP this year, maybe more next.

Of course the US is not alone, France and Germany will be above 3 per cent of GDP this year and next, with Italy close behind, as the first graph shows. Just this week France conceded that it would break the 3 per cent limit of the European "stability and growth" pact for the third year in a row. As for Japan, 6 per cent or maybe 7 per cent, who knows? If the UK squeaks in at under 3 per cent Gordon Brown will still be able to claim relative, if not absolute, prudence.

It is worth focusing on the US, though, for several reasons. First, there is not only a large Federal deficit but also a growing state and local one (next graph). Second, there is huge personal and household indebtedness. Third, there is huge external indebtedness in the shape of a current account deficit of more than 4 per cent of GDP. And finally, because the US bond and stock markets are so large in relation to the rest of the world, whatever happens there will be a profound impact on the rest of us.

It means higher interest rates. You don't have to be a wizard at economics to realise that if there is a sudden increase in demand the price is likely to go up. There has been a sudden increase in demand for money from governments and there are further increases in store for the foreseeable future. These governments, especially the US, will issue huge amounts of bonds and as they do so the interest rate they will have to pay is likely to rise.

True, we are in a world where central banks will try to hold short rates low to combat the danger of deflation. They are quite proud of it. In his evidence to Congress this week, Alan Greenspan, the chairman of the Federal Reserve, suggested that the Fed would reduce rates further if necessary. He further said that improved financial conditions, coupled with the end of the war in Iraq and the Bush tax cuts, "should bolster economic activity in the coming quarters".

Even if short rates remain low, longer-term ones are already on the way up. The reaction to Dr Greenspan's remarks was a sharp rise in the rate on US 10-year treasury securities to just under 4 per cent. Just over a month ago, on 13 June, they were yielding 3.11 per cent.

So anyone who bought 10-year debt a month ago should feel pretty fed up. The capital value will have shrunk by 15-20 per cent. I suspect that this will come to be the turning point in the longer-term interest rate cycle. So much for the notion that bonds are safer than equities.

The Fed will try to stop longer rates rising too much and has promised "unconventional" policies if necessary to achieve this aim. The general view in the US seems to be that it will be able to hold 10-year rates at around their present level, at least for the time being. But interest rates are cyclical; we know that. At some stage short-term rates will have to rise again. What then?

The ABN-AMRO economics team has been doing some work on this, which started by looking at what happened last time. After the early 1990s recession there was a long period of flat rates between 4 September 1992 and 4 February 1994 (next graph). Shares did well during this period, topping out and then going sideways only when the first rise in rates came through. Ten-year treasuries also did well until they got the sniff of higher rates during the back end of 1993. (Remember that lower yields on fixed-interest securities mean higher prices.) Then yields shot up.

This gives a guide to what might happen this time. When does the market think the Fed will start to push up short rates? Don't ask people what they think. Look at what they do with their money.

The futures markets give a clue as to timing and it is some way off. As you can see from the final graph, they predict that the US Fed funds rate will rise in March next year, and the same calculation suggests that the European Central Bank will increase rates in September next year - and the Bank of England in December 2004.

Of course things may not turn out like this, but that is what the markets think right now. Were markets to follow the pattern of the last economic cycle, shares will do well for another nine months (or whenever the Fed tightens), but bonds will do badly both before the tightening and afterwards.

But are things different this time? Unfortunately they are. For a start shares are either fully valued (i.e. quite expensive) or, if you look at the judgement of independent forecasters such as Smithers & Co, very overvalued. Andrew Smithers thinks that "the real bear market hasn't happened yet". His latest paper emphasises the federal and current account deficits noted above and argues that current optimism about the recovery and especially US company profits leave equities very vulnerable to bad news.

A lot depends on whether the US has a large output gap or not. If there is, then it could expand without running into inflationary pressures. But these deficits would not narrow. If there isn't much of an output gap then rising inflation would force the Fed to tighten sooner, which would be bad news for both shares and bonds.

The basic point here, which applies to the rest of the developed world as well as to the US, is that you cannot create a strong economy by financial manipulation. The combination of cheap money from the central banks and large deficits from governments will maintain demand for a while. But eventually adjustment has to take place.

Besides, there are limits to the ability of central banks to provide cheaper money and governments to run up their deficits. The warning light is long-term interest rates. If they rise too much, then they are saying that people don't trust the ability of central banks to lean against inflation or, more alarmingly, governments' ability to pay back their debts.

We are not at panic button stage by any means. Indeed many of us think that the danger of deflation remains the most serious one and that a combination of cheap money and a modest rise in fiscal deficits is, on balance, the safest policy.

But the rise in public sector deficits that is happening in the US is not modest at all - nor indeed is the swing that is taking place in the UK from surplus to deficit. Long-term rates are still very low, but they are turning upwards in every major market. Evidence that officialdom is getting worried about government borrowing comes none too soon - the people who have to stump up the money are also starting to worry and they matter more.

Finally, a small thought for UK home buyers. If Gordon Brown were to find some way of nudging us towards a system of home loans that are funded by long-term borrowing, not short, we would probably already have started to see mortgage rates rising, despite cuts in short-term rates by the Bank of England.

Indeed large government deficits would push up mortgage rates.

I don't think British home buyers would be too thrilled about that. So maybe fixed-rate mortgages are not such a great idea after all.