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Posts Tagged ‘increase in interest rates’

Bernanke Conundrum

Posted by Larry Doyle on June 8th, 2009 7:27 AM |

Overnight markets indicate that Treasury prices are lower and interest rates subsequently higher (remember the inverse relationship between bond prices and interest rates). 2yr Treasury notes are trading at 1.33% and 10yr Treasury notes are trading at 3.85% (both are .03% higher from Friday’s close).

If interest rates are higher, clearly that move must be an indication that economic activity is improving and equity markets should be higher overnight, correct? In “normal” economic times, perhaps that line of reasoning would hold water, but in the Uncle Sam economy, we need to go deeper.

Equity futures indicate our stock markets will open lower by approximately 1%. What’s going on? Welcome to the Bernanke conundrum! What is the riddle wrapped inside our economic enigma? How can Fed chair Ben Bernanke nurse our economy back to health while at the same time maintaining the necessary fiscal independence, integrity, and discipline of robust Fed policy?

Big Ben has used aggressive measures to backstop a wide swath of our markets. In the process, he has created a fair amount of stability but with an effective government guarantee “insurance” policy as the cost of stability. Some of these policies have lessened in size as certain sectors have normalized. However, the major Fed programs remain in place. What are these?

1. quantitative easing: commitment to buy $1.3 trillion in total of Treasury and mortgage-backed securities in an attempt to keep these rates down. Then why are rates rising? More on this in a second.

2. commitment to provide necessary liquidity as needed to support the “wards of the state” including Freddie Mac, Fannie Mae, GM, AIG, Citigroup.

These programs in conjunction with the massive deficit spending programs undertaken by the Obama administration have ballooned our expected funding needs in calendar 2009 to upwards of $3 trillion, a fourfold increase over prior years.

In my opinion, interest rates are moving up much less on any real signs of economic improvement than on these funding needs and very real signs of a monetary printing press malfunction. What’s that? With the Fed Funds rate at 0-.25%, the Fed is literally flooding the economy with cash. Where is that cash going? Is it flowing through to the economy? Not really.

The cash is pouring into the banking system to cushion and support financial institutions from the ongoing losses connected to rising defaults on credit cards, residential mortgages, commercial real estate, and corporate loans.

The market is now very clearly sending a signal to Bernanke, Geithner, Obama and team that if they want to continue their programs as designed (and they do and will), the price, that is the rate of interest, is going up. Why?

The market is very concerned that the flood of liquidity will lead to inflation if not rampant inflation and potentially hyperinflation. How does Bernanke head that off?

Withdraw the very liquidity that he has found so necessary to pour into the financial system. How does he do that?Two ways.

1. increase the Fed Funds rate: that is, make borrowing more expensive.

2. reverse the quantitative easing program so that the Fed actually sells Treasury and mortgage-backed securities into the market and takes liquidity out in the process. What are the impacts of both those maneuvers? Higher interest rates.

In fact, interest rates are moving higher already in anticipation of Bernanke being forced to make these moves. Can Bernanke “thread this needle?” What will happen if interest rates move higher?

Slow the economy, especially housing given higher mortgage rates, and lower earnings especially for financial institutions. To wit, our equity markets are lower overnight.

Nobody said this was going to be easy.

LD

About Those Interest Rates

Posted by Larry Doyle on June 6th, 2009 9:49 AM |

A sharp move higher in interest rates has received a lot of attention lately. In fact, I now believe the focus on interest rates will move to center stage in our Brave New World of the Uncle Sam Economy. Allow me to comment.

I spent my entire career on Wall Street within the bond market, so my professional life has been consumed by interest rates. I don’t know if that is necessarily a good thing, but that’s for another day.

What are interest rates?
Very simply, the interest rate – for whatever financial product – is the “price of money.”

What are the components of interest rates for respective financial products?
Interest rates are determined by three factors:

1. a general level of rates of return in the economy and market: this level is typically viewed by focusing on the shorter maturity U.S. government securities. Uncle Sam is viewed as the benchmark from which all other interest rates are compared. Uncle Sam’s own creditworthiness is coming into question, but that can be a topic for a separate post.

2. a risk component: this factor addresses the creditworthiness of the borrower (be it a global government, a corporation, a municipality, or an individual).  Additionally, while most bonds focus on the risk component as being a function of creditworthiness, there are other risk factors as well, including prepayment risk for mortgages.

3. inflation/deflation: this factor addresses how fixed future returns on bonds are impacted by the general change of prices in the economy. The presence of inflation (a rising level of prices) erodes the value of fixed future returns. In a similar fashion, the presence of deflation (a declining level of prices) increases the value of fixed future returns.

Utilizing these three factors, one is prepared to more effectively understand the nature of interest rates, both from a static standpoint and in a dynamic environment.

Utilizing these components, how and why do interest rates change in a dynamic economy?

Let’s recall that the valuation of any financial product (a stock, bond, currency, commodity) is determined in a dynamic market setting by buyers and sellers assessing three variables:

1. fundamental analysis: from our trusty Investing primer (right sidebar), we see this variable defined as:

an investor can perform fundamental analysis on a bond’s value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings.

2. technical analysis: again using our Investing primer:

A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

3. market psychology: the Investing primer educates us on this variable as well:

The overall sentiment or feeling that the market is experiencing at any particular time. Greed, fear, expectations and circumstances are all factors that contribute to the group’s overall investing mentality or sentiment.

While conventional financial theory describes situations in which all the players in the market  behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can’t be predicted by simply looking at the fundamentals.

Utilizing these tools, let’s review the prevailing level of interest rates in our economy from a chart provided on a daily basis at the WSJ Market Data page linked here at Sense on Cents.

We can assess how all the short term interest rates have come down over the last three years in response to the recession. We are now faced, though, with a move higher in rates given the increased risks of inflation, along with massive demand by global governments, corporations, municipalities, and individuals for credit. That demand, like any demand, is driving the price of money (the interest rate) higher. Is this demand being generated by improvements in the economy, the need to refinance existing debt, or a combination of the two?

Welcome to the word of interest rate analysis for fixed income investments (bonds).

Please share your thoughts, questions and concerns so we can all most effectively navigate the economic landscape.

For more on this topic:

Is The Government Bond Bubble Getting Ready to Burst?
May 21, 2009

Mortgage Refi Activity Is Driving Rates Higher
May 26, 2009

The Wheels Have Come Off Barack’s Bond Bus
May 27, 2009

I will also address the dynamics driving interest rates extensively during my NQR Sense on Cents radio show Sunday evening June 7th from 8-9pm.

LD

P.S. If you like what you see here at Sense on Cents, please add the site to your favorites, share with your friends, and visit/comment often!! Thanks!!






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