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Is this the end of the low-rate era?
Interest rates have jumped quickly as investors begin to fear they've seen their last Fed cut. If the bond market finds its feet, all's well. Otherwise, a vicious cycle looms.
By Jim Jubak
Just a month ago, the yield on a 10-year Treasury note was 3.11%, a 45-year low.
On Tuesday, July 22, the yield on the bond -- to which mortgage rates are keyed -- climbed slightly to 4.15%. But over that month, the bond yield jumped 1.04 percentage points a full third. And investors in the bond took it on the chin, because yields rise only when prices fall. And home buyers were suddenly facing higher rates.
Why is this happening? And how high will interest rates go?
Weve come to the end of the virtuous cycle that pushed interest rates lower and lower while stimulating economic growth.
And weve just begun what could be a vicious cycle that will push interest rates higher and put a damper on economic growth. This vicious cycle will act as a damper on economic growth, and it may be enough to force the Federal Reserve to intervene in the Treasury market more forcefully than it had intended. And it will put pressure on corporate balance sheets and stock valuations. Think of it as the reverse of the virtuous bond-market cycle that helped improve corporate credit ratings and supported higher stock valuations.
But its still way too early to tell if this cycle will push bond yields steadily higher or simply increase bond-market volatility as yields swing in a new, if higher, range somewhere near current levels.
Three big trends come together
To weigh the chances of a steady climb in rates against a range-bound bond market, start with the extraordinary set of macroeconomic trends that all came together last week.
Bond investors heard Fed Chairman Alan Greenspan say positive things about the economy in his congressional testimony. The Fed, Greenspan said, is predicting 2.5% to 2.75% economic growth this year and an acceleration in growth to somewhere between 3.75% and 4.75% next year. The forecast for 2004 is well above the 3.7% consensus among private sector economists. This certainly raises the possibility that an economic recovery will drive interest rates up in the future through a combination of increased inflation and more borrowing by companies looking to expand.
Much more importantly, if the Federal Reserve is correct about the economy, the central bank wont need to cut rates again. In short, theres a very real possibility that bond investors have seen their last interest-rate cut for this cycle.
Greenspans testimony came right on the heels of another disappointment for the bond market: the Feds decision in late June to cut short-term interest rates by just 25 basis points to 1%. (100 basis points make up 1 percentage point.) The Fed could cut rates another 25 basis points if necessary, Greenspan said. But he also lowered the odds that the bank would undertake the unconventional move of intervening directly in the bond market by buying Treasury notes to force down longer-term rates.
And even before Greenspan had finished testifying, the White House released new budget figures showing that the federal deficit was running far ahead of projections made earlier this year. The Bush administration now sees a bigger-than-expected $450 billion deficit for the 2003 fiscal year that ends in September. That projection is 50% higher than the administrations February projection.
And this is just the start of a string of deficits that stretches as far as the eye can see, or at least as far as 2008, the end of the official White House forecast. The higher deficits raise two possibilities:
- Interest rates will pick up as government demand for financing competes with corporations.
- Foreign investors will demand higher rates as well as compensation for the greater risk that huge federal deficits pose to the value of the dollar and hence to the value of their bonds.
All this news sent the interest rate on the 10-year Treasury note climbing and the price of that bond falling.
The message that investors heard and acted upon, however, was not that inflation was just around the corner or even that growth was about to roar ahead, overheating the economy. The message investors took away was this: Theyve seen the bottom for interest rates for this cycle. So, bond holders kept selling, pushing bond prices lower -- and yields higher.
The technical forces at play
So, why does the bond markets conviction that the market had seen the low in interest rates have so much power to move bond prices? Lets look at the technical details of the market over the last few months.
You and I may buy bonds to diversify our portfolios and generate current income, but we wont move the bond market in the short-term. In the short run, the course of bond prices is influenced by things such as hedging and strategies to capture the spread between the long and short ends of the yield curve. (The yield curve graphs the interest rates paid on everything from short-term debt such as three-month Treasury bills to long-term instruments such as 30-year bonds. The greater the difference between the yield on short-term and long-term instruments, the steeper the curve.)
For example, many institutions in the mortgage business have been buying 10-year notes and 30-year bonds as insurance against what they call prepayment risk. Theyve been worried that interest rates would fall further and homeowners would refinance their existing mortgages at lower rates. Even if a bank managed to hold on to the individual mortgage, the new loan would pay a lower rate of interest than the old one, and the bank would see a drop in its interest income. Add together enough refinancings, and the shortfall could be huge.
Buying 10-year Treasury notes has been one way to hedge this prepayment risk because the price of the Treasurys would climb if interest rates fell. And those gains would help offset the loss of income from homeowners who prepaid mortgages.
Bond speculators looking to profit from the spread between short-term interest rates and long-term yields were also big buyers of notes and bonds. The Fed had driven interest rates so low at the short end of the yield curve that bond speculators could borrow money in the short-term money markets at just about 1%. They could then use that cash to buy 10-year Treasury notes yielding 3% or better. Since the money used for the investment was borrowed, the return on the small amounts of actual capital that these speculators put up was much higher than the nominal 2% spread between the short and long rates.
And as long as rates were falling and bond prices were rising, these speculators reaped some nice capital gains, too.
In fact, the demand for bonds generated by these strategies built on falling yields and rising prices helped keep bond prices climbing and yields falling. Thats what I mean by a virtuous cycle: Lower interest rates created demand for bonds. That demand, in turn, drove yields lower and prices higher, creating more demand for bonds. And so on.
Setting up a vicious cycle
Interest rates dont have to rise and bond prices fall to make these two strategies much less attractive. All interest rates have to do is to show signs that theyre near the bottom for this cycle.
If interest rates arent about to fall further, lenders dont need to insure against prepayment risk on their mortgages. And the speculative trade gets much less attractive. The yield spread still exists, but the extra gain from rising bond prices vanishes.
In both cases, too, what had been a risk-free strategy starts to carry the potential for loss. If yields start to climb, pushing bond prices lower, mortgage lenders could actually lose money on their prepayment insurance. Falling bond prices could be disastrous for a highly leveraged speculator who has secured loans against the value of his portfolio.
And so a vicious cycle kicks in. Hedgers and speculators sell, fearing that rising yields and falling bond prices will create losses. And that selling puts more supply on the market exactly when demand is falling, resulting in exactly the falling bond prices that everyone was trying to avoid in the first place.
But as long as this selling by hedgers and speculators isnt reinforced by actual inflation or signs of a recovery so strong that it will drive up interest rates, then this vicious cycle cant drive the bond market to extremes. On the evidence of the last few days, at a yield of 4.2% or so, another group of bond buyers enters the market attracted by the higher yields created by the unwinding of hedges and speculative buying strategies. To this army of income-hungry investors, 4.2% is a significant return, in and of itself, even if the price of bonds doesnt climb to create capital gains.
These investors arent afraid of steady bond prices but, in fact, welcome them when they come along with yields above 4%. Especially if that kind of yield is being offered when the direction of the stock market seems uncertain.
Equilibrium at around 4%
Right now, I think the odds are that the bond market and long-term interest rates will find a new equilibrium somewhere between 3.75% and 4.2%. Thats roughly where rates stood before the Fed jawboned them down in May with its talk of the dangers of deflation.
But thats by no means guaranteed.
The success of that deflationary danger gambit seems to have led the Fed to overconfidence. Chairman Greenspan began to talk as if no further interest-rate cuts would be forthcoming and also took unconventional measures such as direct intervention to lower long-term rates off the table (though he later denied taking anything off the table.) The bond market, taking the Fed at its word, promptly sent long-term rates higher.
Now the Fed must decide if it will let these higher long-term rates stand for a while or use exactly the combination of further rate cuts and unconventional intervention that it seemed to rule out just last week. Already the Fed has pulled out the deflationary rhetoric again. In a July 23 speech, Federal Reserve Gov. Ben Bernanke said the Fed must be ready to take short-term rates to 0% and that deflationary pressures could remain a danger, even if the economy recovers, well into 2005.
More prepayment hedges and more speculative bond portfolios are still to be unwound, and these will keep pressure on bond prices. Income investors certainly remain hungry for safe yields above 4%. And the Fed clearly isnt done jawboning.
The bond market is clearly a much more uncertain place than it was in the days when investors could count on interest rates marching ever lower
New developments on past columns
Dont be fooled by earnings headlines
In my July 16 column, I questioned how much Wall Street had changed its ways when it came to reporting earnings. In the last week, Amazon.com (AMZN, news, msgs) and AOL Time Warner (AOL, news, msgs) have provided glaring examples of just how much things havent changed. In Amazon.coms July 23 earnings release, you have to keep reading and reading and reading to discover that the company lost money, 11 cents a share to be exact, in the second quarter. That news comes well after the rosy numbers showing big increases in operating cash flow, free cash flow and operating income. And what number did Wall Street choose to report? Not the 11 cents-a-share-loss but the 10-cents-a-share pro forma in net income. But my favorite earnings press release for the quarter so far has - to be AOL Time Warners July 23 report that begins with a full paragraph explaining how the company, because of new accounting rules from the Securities & Exchange Commission, isnt going to use EBITDA (earnings before interest payments, taxes depreciation and amortization) anymore. But what figures does the company report in the next paragraph? Operating income before depreciation and amortization. Since operating income is figured before interest payments and taxes, this figure is just the old EBITDA in all but name. Hows that for accounting reform?
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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