Sunday, October 29, 2006

Low interest rates to continue for at least a year and probably indefinitely

Despite the fact that the Fed has raise the fed funds target interest rate up to 5.25%, it is market forces which determine longer-term interest rates. Many loans and mortgages are at least indirectly linked to the market yield on the 10-year Treasury note, which on Friday was only 4.67%. According to Freddie Mac, the average 15-year fixed mortgage was only 6.10%. That is up moderately from 5.69% a year ago, but still a very decent rate, and down moderately from the July peak of 6.44%.

Banks and "lenders" no longer actually finance mortages themselves, but simply originate them, collect fees, and then sell the mortgages to be packaged into mortgage-backed securities (MBS) which are purchased by investors. As long as the rate of return on an MBS is significantly greater than the yield on the 10-year Treasury, investors will continue to flock to MBS. And, every increment of downwards movement in the 10-year Treasury yield increases demand for MBS, and an upwards move in MBS price pushes its yield lower, enabling consumers to get cheaper mortgages.

There are many reasons why Treasuries remain very attractive investments, not the least of which is the fact that quite a number of "boomers" are rapidly approaching retirement age and incrementally shifting assets from stocks to fixed income investments. Treasuries are very attractive for that purpose. Sure, other higher-yielding investments can be found, but a core of zero-risk Treasuries is a great foundation for most portfolios.

There is also a lot of anxiety about the stock market and the economy, which both increase demand for "safe haven" Treasuries. The sagging of the recent commodities bubble has also led to a shift of assets into safer Treasuries.

Quite a number of notable commentaters are very convinced that the economy will be very weak next year, possibly even with a significant recession. This mentality also causes a shift into safe Treasuries, especially with an expectation that the Fed will be forced to lower its fed funds target interest rate, possibly from 5.25% to 4.75% or even lower. Such a possibility attracts a lot of bond speculators who seek to make a quick profit in such a shift of rate expectations.

My view is that the economy will be just fine this Winter, next Spring, and next Summer, but the anxiety about the future will persist and that will keep rates down.

In fact, I believe the anxiety about the future will persist to some degree until the day when the Detroit automakers, the airlines, the phone companies, and even domestic manufacturers are all back on track and exhibiting strong revenue and profit growth. Needless to say, that prospect is probably at least three to seven years in the future, but the implication is that we will have nagging anxiety about the strength of the economy holding down interest rates for much of that period.

The recent episode of inflation was induced by a combination of the housing boom and rampant commodities speculation, but both factors are now behind us. Contained inflation expectations are one of the keys to holding down long-term interest rates, and it looks like we will have such contained expectations for years to come, and next year with a high degree of certainty.

-- Jack Krupansky

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