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January 27, 2010

Treasury Rates Moving Up, At Least They Were Part 1


Since the financial crisis began, I have felt that the treasury bond market would experience a sharp increase in bond rates after a prolonged period of government intervention. I felt that the interest rate increases would be strong enough to hamper the economic recovery.

Bond rates are beginning to move, but I’m not ‘tooting my horn’ yet and here’s why:

Any novice observer could have looked at the bond market several months ago and predicted a rise in interest rates, mainly because rates could not get any lower. It’s sort of like saying the worst team in the history of the league will finish better next season. Short term treasuries were actually yielding less than what they were worth, meaning someone who bought a one month treasury actually got less money than they paid back when it matured. But, there are differences between my prediction and what has happened so far.

Unless I’m dreaming, I’m pretty sure that I predicted the rate increases we are seeing in December would come in Q1 2010. So, for those increases to be coming earlier than I predicted is slightly alarming to me. It raises the prospect of a possible “second wave” of this crisis. This phase would not be as bad as what happened in September 2008, as it would be more driven by fear than anything else.

The government is borrowing at 6 times the annual rate that it did during the Bush Administration. The central part of my theory is that the private market does not have the capital to buy these treasury bonds at a rate of $1.8 trillion per year. When demand for treasuries stops, interest rates must rise in order to attract buyers. With treasuries rates affecting nearly all interest rates in our market, an increase would make it more expensive to borrow money across the board in the U.S.

High rates could also scare investors out of the bond market. While this is good for stocks and consumer lending, a sharp increase in interest rates would hurt the consumer market. Who wants to buy a house with an 8% mortgage? Who can afford the monthly payments at that level? Therefore, it is clear that higher rates will lower consumer demand for credit, and possibly slow our recovery. However, in this situation, there is a counter-balance. Banks seeing consumer demand slowing, would go back to the bond market, buy bonds, and treasury rates would fall again. However, by going back to the bond market and lending more to the government, that money will need to be pulled away from the private market. Those who lend to the federal government can either lend the money to the private markets or the government.

So why am I writing this blog with a tone of concern?

My worry is that the government’s intervention to hold rates down below their real market rates, could lead to a sharp bounce-back in the opposite direction. This would send interest rates higher than they should be. While the above scenario (of banks buying more treasuries) could help dampen the high rate theory, an unstable treasury market with rates bouncing in one direction or another could scare investors from buying bonds, and banks from issuing credit. Again, unreasonable rates can lead to a fear driven panic.

Let me illustrate.

As part of its commitment to keep Treasury rates down, the Fed bought $300 billion in Treasury notes earlier this year. Buying treasuries increases the demand for bonds, therefore interest rates fall. Does the Fed have a strategy to unwind essentially one normal year’s worth of debt back into the economy? If it sells this debt all at once, rates will jump because of the huge jump in bond supply versus demand. Even in an orderly and gradual unwinding, rates will have to increase to accommodate the increase in bonds. Gradually higher rates can be supported by a growing economy.

But what does the Fed do if rates jump too high? Buy the sold bonds back and perhaps even more than that?

The Fed’s involvement is dangerous because it can make our bond market dependent on the Federal Reserve. Bond market independence is the key to proper pricing of bonds, and therefore, market interest rates. Interest rates being held below their market levels for an extended period of time can create bubbles (a la the last bubble we went through) and rates bouncing too high can cause long-term depressions (a la the Great Depression).

The Fed will have to dance a tightrope in order to unwind itself from the bond market (not to mention the trillion dollar TALF holdings, which I will mention in another blog).

As an investor or consumer, look for interest rates to increase by at least 1.5 to 2.5% in 2010, but also watch for the threat of a 4 or 5% increase. Make sure you pay additional attention to any variable loans you have because the rates will adjust upwards. If you can convert any variable loans to fixed (like your mortgage), that would be a good idea.

I noticed in the last couple of weeks that treasury rates have gone back down, but not on economic news. It was because a large ‘mysterious’ buyer entered the treasury market on January 14th. On Friday, I will reveal a recent study I conducted on the treasury market and the shocking conclusion.

Here’s a good Rick Santelli video that kind of goes with today’s blog.

In summary:

1) Interest rates have risen, like predicted, but sooner than expected.

2) Expect interest rates to continue to rise into 2010.

3) Watch for any extreme jumps in interest rates that can disrupt the economy.

4) Do your part to make sure you don’t get caught in a rate jump.

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