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Sources of Pressure on US Interest Rates


Rising interest rates are bad news for bondholders, especially those who hold longer term maturities, and will only make economic growth more difficult to achieve.

Editor's Note: This article was written by Robert Barone, head of Ancora West. Barone currently serves on AAA's Finance and Investment Committee which oversees $5 billion of investable assets.

The conventional wisdom is that, after nearly 30 years of decline, US interest rates have nowhere to go but up, and rising interest rates are bad news for bondholders, especially those who hold longer-term maturities. (As rates rise, bond prices fall with the severity of the fall directly related to time to maturity.) This article outlines existing upward and downward pressures on bond rates and outlines emerging issues that have the potential to turn into a dollar crisis.

Upward Rate Pressures

  • The financial media believe that the US economic recovery is finally taking off. Much of the data today indicate better economic performance, from holiday sales to better news on the jobs front. Fourth-quarter GDP likely rose 3.5%, and the momentum may push first-quarter growth toward 4%. The 2% Social Security tax cut for wage earners will likely help spur first-quarter consumer spending (but after that, spending growth isn't impacted until the 2% is taken away).

  • The world's economy appears to be growing, especially in the BRIC countries (Brazil, Russia, India, China) and the emerging markets. Added demand from a recovering US economy will put upward pressure on resources, especially commodities, and is likely, at least initially, to put upward pressure on rates.

  • Rates also rose in 2010's fourth quarter with the implementation of the second phase of the Fed's quantitative easing program (QE2). Bernanke indicated in his August address at the Kansas City Fed's Jackson Hole meetings that one of the purposes of QE2, including the reinvestment of the cash interest payments and mortgage paydowns back into the markets, was to make sure Fed policy didn't become passively tighter by allowing bank reserves to shrink when such cash payments were made. In effect, Bernanke indicated that the upcoming QE2 program was intended to keep long-term rates near their low points to "stimulate" housing and the economy. Today, with the run-up of more than 110 basis points (bps) (1.1 percentage points) in the 10-year Treasury, we know that QE2 didn't accomplish that goal. I suspect that while some rate rise could be attributed to increasing worldwide economic activity and better prospects at home, much of that 110 bp rise was also due to widespread criticism of a QE2 policy that is simply monetizing trillions of dollars of new federal debt. More on this below.

Downward Rate Pressures

  • US Economic Growth faces headwinds:

    • While the official headline unemployment rate (U3) is 9.4%, a more comprehensive definition (U6) puts the rate closer to 17%. And, using consistent definitions from the early '90s would put the rate closer to 22% (see While there appears to have been better news on the labor front of late, it's hard to see significant economic growth as long as such high levels of unemployment continue.

    • To further exacerbate this, the new GOP-controlled House of Representatives has spending restrictions as a major agenda item, which will slow economic activity by some multiple of the spending reduction.

    • There is no longer any doubt that residential real estate is entering a second dip. Rising 10-year bond rates over the past three months have raised mortgage rates and made homes less affordable. The Case-Shiller Index of home prices shows a definite downward movement in prices, and Shiller himself has indicated that the next leg down could be as large as 20%. Such a price movement will do two things:

      a) cause a negative "wealth effect" for continuing homeowners (this may amount to hundreds of billions of lost value), and

      b) it will accelerate the already rapidly rising trend in "strategic" defaults (people who can afford their mortgage payments who choose to walk away anyway).

    • There remain huge fiscal issues at the state and local government levels. Most states are facing current budget deficits, but the poster child for kicking the can further down the road remains California. It prefers temporary patches, hoping that things will soon return to "normal", i.e., pre-2008. Like the City of Chicago, which sold its parking meters to Wall Street and some sovereign wealth funds for what appears to be significantly less than fair value, California is selling its state-owned office buildings to raise some cash to partially patch its current deficit. The selling price appears low relative to the lease terms, but worse, the legislature isn't dealing with the structural causes of the deficit. As a result, deficits are bound to reappear in future fiscal years. Wonder what happens when all of the salable assets have been sold?

    • Clearly, more layoffs of state and local employees are coming. If not layoffs, then lower wages and benefits. In either case, this implies lower, not higher, levels of consumer spending.

    • Finally, no one has addressed the huge level of unfunded liabilities in state pension plans. Because insolvency of the plans is not imminent, the politicians aren't dealing with it. New Jersey Governor Chris Christie, who has done more than any other governor in pushing his state toward fiscal responsibility, has said that he simply has no idea about how to deal with the magnitude of the unfunded liability. Even if the current budget bleeding stops, it will be years of fiscal austerity and high levels of taxation to work out of these situations.

    • Food costs have gone up rapidly in the US (and in the rest of the world, causing worries about social unrest in some underdeveloped countries). Gasoline prices, too, have risen rapidly in the past couple of months. And each cent takes some billions of dollars out of consumer disposable income. Higher food and energy prices will stunt economic growth and put downward pressure on rates.

  • The World's economy may slow.

    • China has raised reserve requirements on its banks and put in other restrictions on real estate to try to deflate a growing real estate bubble. Today, if China sneezes, the rest of the world catches a cold (we used to say this about the US). And if China slows, so will all of the commodity producers (Australia, Canada, Brazil, Russia …)

    • The European debt crisis is about to enter its third act -- Portugal (Greece was Act I, Ireland was Act II). The debt crisis and the adoption of austerity throughout the continent will surely slow economic growth there. Furthermore, if the opposition party in Ireland wins the March elections (currently leading by 20 points in the polls), it has vowed to fix the sputtering Irish economy by removing much of the austerity via a "debt restructuring" (shorthand for "default"). If that occurs, it's likely that the rest of the European weaklings will follow suit. Surely, panic would spread worldwide, the dollar would strengthen, and interest rates would fall.
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