Interest rates are rising even before the Federal Reserve moves

12/11/2009 11:49 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The march to higher U.S. interest rates is on.

Oh, the Federal Reserve won’t increase short-term rates, the only ones it directly controls, for an “extended period” yet. I still think we’re looking at mid- to late-2010 before the Fed moves. Ben Bernanke and Company want to be dead certain that the economy is locked into sustainable growth before they risk raising interest rates.

But long-term rates aren’t waiting on the Fed. They have begun what looks like an extended move higher.

At the end of 2008 the difference in yield between the two-year Treasury note and the 30-year Treasury bond was 1.91 percentage points. After yesterday’s auction of $13 billion in 30-year bonds the difference in yield, what’s called the yield curve, between 2-year and 30-year Treasuries was 3.73 percentage points. (At 11 a.m. this morning is was 3.71 percentage points.)

That’s the biggest gap between two-year and 30-year yields in 29 years, according to Bloomberg. Over the last five years, spread between 2-year and 30-year Treasuries has averaged just 1.32 percentage points.

The gap between 3-month Treasury bills, yielding 0.02%, and 30-year bonds, yielding 4.54, was even bigger at 4.52 percentage points.

What’s going on? Two trends are driving long-term yields higher while short-term yields are anchored in place by Federal Reserve policy.

First, every bond investor in the world knows that the U.S. has to sell a truck load of bonds this year to pay for what the U.S. Treasury projects as a $1.5 trillion deficit for the 2010 fiscal year. That’s on top of the $1.4 trillion deficit for fiscal 2009.

And every bond investor in the world knows that the 2010 deficit won’t mark the end of the U.S. budget whole. There’s red ink as far as the eye can see—although with an end to the recession and to the huge spending packages required to bailout of the financial system and stimulate the economy, the size of the deficit should start to shrink.

Looking at that huge supply, the dead certainty that the Federal Reserve will start raising interest rates in 2011 of not 2010, and the almost guaranteed return of inflation once the economy is growing again, bond investors want more yield today than they demanded yesterday.

The longer bond investors have to wait for their money—that is the further out the maturity of the Treasury bill, note or bond—the higher the rate investors will demand because every day brings the arrival of  more U.S. borrowing, higher Federal Reserve interest rates, and higher inflation.  

Quite frankly given the likely future for interest rates, the deficit, and inflation, I’m only amazed that bond yields aren’t higher. Thank the fear generated by things like the Dubai World debt restructuring and the downgrade of Greek sovereign debt for that. Nothing like a solid dose of fear to make the safety and liquidity of U.S. Treasuries worth taking a lower yield.

But this isn’t all that’s driving long-term rates higher.

Second, there’s the U.S. Treasury’s effort to extend the maturity of the Federal government’s debt. In an effort to save interest costs, the Federal government has issued quite a bit more short-term debt than long-term debt. Makes sense, no? Look at the savings from paying 0.02% on a 3-month t-bill instead of 4.52% on a 30-year bond.

But the Treasury can read the trends as clearly as bond investors can and these officials know that interest rates are headed up with time. So they’re trying to sell more long-term debt now, even though that increases current costs, so that they can lock in today’s relatively low long term interest rates for the long term.

The Treasury has announced that it will sell fewer short-term Treasury bills and 2-year and 3-year Treasury notes this year and more 7-year, 10-year, and 30-year notes and bonds in an effort to stretch out the average maturity of Treasury debt to six of seven years. From the mid-1980s to 2002 the average maturity of the Federal debt ranged from 60 to 70 months—five years to a little less than six years. In February 2009 the average maturity had dropped to just four years.

The result is that at a time when the U.S. Treasury has to sell more debt in general, it also must sell more long-term debt in particular.

That puts more upward pressure on the longer end of the yield curve.

I think the recent trend for higher long-term rates isn’t over by any means. The U.S. deficit is going to be higher in this fiscal year than in the last one. The need to entice buyers of long-term debt to stuff even more into their portfolios will be greater. And every day of decent economic news brings the debt market closer to the day when the Federal Reserve will start raising short-term rates. That will ratchet the entire interest rate curve upwards.

Rising interest rates, of course, mean that holders of existing bonds see the price of the bonds fall—so that the yield keeps up with the yield offered by newly issued debt. That leads bond investors to demand even higher yields so that they can compensate for declines in price.

That will keep downward price pressure on all yield vehicles for the next year and beyond. And it’s one reason that I’m willing to give up some current yield in my Dividend Income Portfolio with recent buys in order to own shares of companies that are likely to be increasing their dividend payouts as the economy recovers.

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