Recent months have seen historical lows in interest rates. Two key factors have been a rush by investors to the safety (real or perceived) of US Treasury bonds and unprecedented intervention in financial markets by The Fed and Treasury. With rates so low it’s obvious the only place they can go is higher. Will this happen? Sure. Soon? Likely. Magnitude and impact? Unclear. Let’s take a closer look…
REASON #1: GOVERNMENT INTERVENTION
Talk of an “exit strategy” and an end to government intervention has dominated the airwaves. The Fed announced they will discontinue their purchases of Treasuries by October 31st, 2009. March 2010 will bring about the end of its ABS/MBS (“assetbacked securities” and “mortgage-backed securities”) purchases.
REASON #2: CREDIT DEMAND
The demand for credit will increase as economic expectations continue to improve. Businesses will ratchet up capital expenditures and rebuild inventories. Consumers will continue to do what they do best – consume.
REASON #3: ALLOCATION OF CREDIT
Lenders will reallocate their supply of credit away from safer assets in favor or riskier assets. Demand for Treasuries will drop in tandem.
REASON #4: FISCAL DEFICITS
Unless Obama, Pelosi, Reid and gang plan to hike tax rates to 84,000% to pay for their spending plans we’re looking at annual deficits to be financed by massive issuance of Treasuries. The supply/demand imbalance will put upward pressure on interest rates.
REASON #5: (LACK OF) MONETARY POLICY
Leadership is seemingly indifferent to defending the Dollar. Continued declines increase risks associated with owning Dollar-denominated assets.
Rates are clearly headed higher. There’s no debating the point. The impact on the economy isn’t as clear. The higher rates rise the tougher it will be to heal the housing market and the perpetually stretched consumer. Political responses will have to address the delicate balancing act between market forces and populist sentiment.