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HomeAbout 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!!
Is the Government Bond Bubble Getting Ready to Burst? UPDATE>>
Posted by Larry Doyle on May 7th, 2009 2:59 PM |
I have tried to highlight my concerns on interest rates for the entire year. Despite the Federal Reserve “cutting checks” to buy hundreds of billions in U.S. Treasury bonds and mortgage-backed securities, the global demand for credit (meaning global governments, companies, and municipalities issuing MASSIVE supply of bonds) is driving rates higher.
As I wrote in my post from April 30th, the U.S. Treasury market has been faced with underwriting tens and now hundreds of billions in government debt on a regular basis. The 30yr government bond auction today was not well received and interest rates have moved higher by 10-20 basis points (.10 to .20%).
What are the implications of higher rates?
1. Increased cost of financing the deficit.
2. Upward pressure on other rates, primarily mortgage rates.
3. Longer time for economy to improve given higher interest costs.
4. Given the massive global government deficits, the access to credit for private enterprise is negatively impacted. This is known as crowding out.
As I referenced the other day, “We Still Have To Pay The Bill.”
Bloomberg reports, Treasuries Tumble as Bond Sale Draws Higher Than Forecast Yield.
From my piece at the end of April:
The equity markets have rebounded significantly over the last seven weeks. The Dow and S&P are now down approximately 4-6% on the year. The tech heavy Nasdaq has distinguished itself and is up approximately 10% on the year.
At this juncture, if the equity markets are implying that the economy will not slip into Depression, then the bill for the stability in equities is being transferred to participants in the bond market. Government bonds are facing an almost weekly avalanche of tremendous supply. This week the market is absorbing over $100 billion in 2yr, 5yr, and 7yr Treasury securites. Take a deep breath and next week the market is faced with over $75 billion in 3yr, 10yr, and 30yr government securities. The Treasury is likely going to sell 30yr government debt on a monthly basis!!
The Federal Reserve has been the biggest buyer of Treasury and mortgage-backed securities. The Fed’s balance sheet may be large but it is not endless. What have 10 yr. Treasury securities done on the year? Even in the face of massive buying of these securities by the Fed, the 10yr has backed up almost 1% to a current level of 3.1%. That rise in rates is very significant.
I have maintained and continue to maintain that interest rates will move higher given the overwhelming demand for funds by global governments to pay for deficit spending. Central banks around the world may try to hold the respective bond markets up and interest rates down but investors will continue to demand a higher rate of interest in the process.
As government rates move higher, mortgage rates, and other corporate rates will likely move higher as well. If we get a whiff of early signs of inflation which I believe is coming these rates could ratchet higher and the bubble in the government market would not merely burst but would actually explode.
LD
