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Here Come Higher Interest Rates   August 12th, 2009
It's been inevitable for months, but now should really kick in       

 
QUICK OBSERVATIONS

More observations...
 

I've been predicting since at least March that higher interest rates were coming due to all the borrowing and money-printing the government was doing. We had a good first glimpse of higher interest rates in late May, but now I suspect we're about to see the real thing.

As I wrote back in March, the idea of the government printing money is dangerous. In the mid- to long-term it can only lead to pressure on prices (inflation)--and inflation leads to higher interest rates. Likewise, the government borrowing massive quantities of money to fund "stimulus" packages and other deficit spending means that the government is competing with borrowers in the private sector for a limited amount of money. This competition also leads to higher interest rates.

So for the last five months this administration, with a cooperative Federal Reserve, has been engaging in the borrowing and printing of money to a massive degree. As expected, interest rates trended up for months, peaking quickly in May. Interest rates would have been pushed up faster and higher by the intensive government borrowing if it weren't for the Federal Reserve simultaneously printing money to buy U>S. Treasury bonds.

When the Federal Reserve prints money to buy U.S. Treasury, the increased demand for Treasuries (because the Federal Reserve is buying bonds in addition to everyone else) causes the price of U.S. Treasury bonds to increase--and that brings down interest rates because interest rates move in the opposite direction of the price of the bonds. So Obama's massive borrowing has put upward pressure on interest rates, but the Federal Reserve's policy of printing money to buy bonds has been counteracting that pressure and kept interest rates mostly stable.

But this cannot last forever. Printing money is increasing the money supply which will eventually cause inflation and devalue the dollar. The Federal Reserve knows this and has, always, been saying they have an "exit strategy." That basically means they have a policy planned (hopefully) to keep inflation from skyrocketing as a result of all the money they're printing.

The Federal Reserve today announced what could be interpreted as the first leg of their "exit strategy."

The FOMC noted it would continue a program to buy $300 billion of Treasury securities and said it would 'gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October,' for the first time putting a date to end any of its programs to inject cash into the economy.


This means the Federal Reserve has announced a slow termination of their ongoing printing of money and monetizing Obama's deficit. There will most likely be some consequences over the next few months as the money-printing operation shuts down:

  1. Higher Interest Rates. As the Federal Reserve stops buying U.S. Treasury bonds, the price of those bonds will fall because there will be lower demand. Since, as mentioned above, interest rates and bond prices move in opposite directions, that means interest rates will rise. This will drive up interest rates on mortgages quite quickly, and will eventually push up the interest rates on credit cards and automobiles.

  2. Harder for Obama To Borrow Money. The Federal Reserve has been printing money to loan to the Obama administration because, otherwise, there wouldn't have been enough to fund his spending. Now that the Federal Reserve is stepping back, the government is going to have to borrow more money from the private sector. But the stock market is having a bull run right now so it's not necessarily going to be easy to get people to invest in low-yield government bonds. So, again, the government is going to have to offer higher interest rates to attract money. That's going to help push interest rates higher.

  3. Weak Recovery. There's not all that much money available to be invested right now. And with Obama's administration having to borrow an increasing amount from the private sector, that means there will be less money available for the private sector to invest in a recovery. This could result in a very slow recovery, or maybe even kill a recovery. Businesses need to be able to borrow money to fund their growth. If that money is not available, or is unavailable due to high interest rates, growth is going to be muted.

  4. Inflation. There's a lot of money flooding the economy right now and it doesn't appear the Federal Reserve thinks this is a problem. But I suspect all that extra money is going to translate into inflation sooner rather than later. Higher inflation always pushes interest rates higher because no-one wants 3% interest if inflation is 4%. So all that money created by the Federal Reserve is going to drive inflation which is going to combine with the previous two issues to push interest rates even higher.

  5. Higher Fed Rate. Eventually the Federal Reserve is going to raise short-term interest rates to try to slow the inflation they know is coming. While short-term interest rates are not directly linked to longer-term rates, they are completely disconnected. So expect higher Fed rates to also put upward pressure on interest rates.


So we have multiple factors that are going to be combining to push interest rates higher between now and October.

If the Federal Reserve really follows through with its plan to slow and stop the printing of money to buy U.S. Government debt, expect interest rates--including mortgage rates--to increase over the next two or three months. Without the Federal Reserve manipulating the interest rate market, market forces will take over and with all of Obama's borrowing, that means higher interest rates.

The only things that would seem to be able to slow the rise in interest rates are the Federal Reserve deciding to keep printing money, the stock market tanking, Obama drastically reducing his deficit spending, or the determination that we aren't really in a recovery.

How high will interest rates go? I have no way to know. But if mortgage rates peaked near 6% back in May with the Federal Reserve printing money at full speed, I would have to think that without the printing press rates will have to go quite a bit higher than that. We'll just have to see.

    Update next day: An article on CNN says essentially the same thing.

    "With the Federal Reserve beginning to wean the markets from its repurchases of Treasury debt, there will be less to restrain mortgage rates if the economic data continue to improve," the report said. Bond yields tend to influence mortgage rates.


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