A few thoughts on the current interest rate picture, and why it’s just about inevitable, despite the lurches and false starts from the U.S. economy, that long-term interest rates are set to rise.
First, with a national deficit that will crest $1.6 trillion by the end of 2010, the U.S. government desperately needs to attract buyers of U.S. Treasuries. Typically, the government can only raise money in two ways — by raising taxes and borrowing money. The former is politically untenable — at least right now — but the latter is in play.
The fly in the ointment is that Treasuries aren’t in big demand by investors. There’s a cloud hanging over the U.S. Treasury market, as some investors are increasingly worried that the U.S. will follow Greece into bankruptcy, unable to pay its debts and make good on its bond obligations. This is probably a long shot, as most economists say that the U.S. economy is in much better shape than Greece’s markets, and that investors have little worry about the U.S. honoring its debts.
But the fact that the subject is even on the lips of (mostly foreign) investors is worrisome.
Second, investors aren’t exactly thrilled about the current rate of return they’re getting on their investments in Uncle Sam. The Federal Reserve’s decade-long policy of keeping interest rates low has fueled low rates of return from Treasury yields — the average yield dropped from 6.58% in 2000 to 3.85% so far this year, according to the Treasury.
Thus, the return on investment for 10-year Treasuries has fallen by over 270 basis points over a 10-year period — and the 3.85% yield we’re seeing now is a vast improvement on the 2.46% interest on 10-Year Notes we saw in January 2009. Investors are increasingly looking at Treasury investments and deciding they can do better elsewhere, and that’s a scenario the U.S. government can’t afford.
So it’s no coincidence that the Federal Reserve is actively looking to sell the $2.29 trillion in securities it currently has on its balance sheet. That threat alone, combined with aggressively-priced U.S. Treasury auctions, should force long-term interest rates higher, as consumers would have to pay more for mortgages and businesses would have to pay more to borrow money.
As rates go higher, more investors will jump into the U.S. Treasury pool, thus making White House economists happy, if not the American public, which isn't too pleased about current government spending.