Why Interest Rates Are Not Likely to Rise in 2010

Includes: IEF, TLH, TLT
by: Kimball Corson

In his article, Why Interest Rates Will Almost Certainly Rise in 2010, Charles Smith basically argues that the world is largely satiated with Treasuries and that for the Treasury to sell more, it will have to raise the interest rates on those instruments to move them and other interest rates will therefore follow. I don’t think so. Here is why in a nutshell.

To consider how the Fed and Treasury might deal with interest rates in 2010, we need to stop and look at where the economy is. Most agree unemployment is going to be a continuing and serious problem for 2010. Most also agree that commercial lending, especially by banks, is still somewhat frozen. Banks look askance at most putative borrowers and those borrowers in turn seriously wonder to what good real use they might put any borrowed funds. Banks themselves are still in a deep hole. But for TARP I and II funds and an easing of the mark to market rules, they would really still be in the dog house. Also, defaults in the commercial real estate market are deemed to still be in front of us. Don’t count on really health banks that do much lending any time soon.

Finally, the economy is not exactly rocketing back up. Third quarter GDP growth initially came in at 3.5%, then was revised down to 2.8% and then further revised downward to 2.2%. When it was 3.5%, most pundits claimed we had to back out transient government efforts to boost that figure to get real GDP growth: they figured real GDP growth was about 0.5% after doing that. If we do the same for the latest 2.2% figure, we have negative GDP growth of almost 1%. Not a happy result. It reveals the real economy is still tanking, a point with which Main Street would readily agree. The Fed does too, but it won’t say so.

So the question becomes, what are the Fed and the Treasury going to do about the economy as far as interest rates are concerned. My take is that the Fed will maintain its zero interest rate policy with quantitative easing, the government’s deficits will continue and the Treasury will continue to sell Treasuries with low returns without much of a problem.

Interest rates will not rise markedly because the Fed will not let that happen. It will initiate another large round of Treasury purchases and agency debt purchases, using quantitative easing to maintain its zero interest rate policy and interest rates generally will remain artificially depressed to very low levels. The real economy is still sufficiently bad off that the threat of inflation is not something the Fed is going to worry about much. Also, given the fact banks still are not lending, the Fed still has plenty of time to mop up excess bank reserves or high powered money in the banking system to avoid serious inflation, if that is necessary. Just increasing the reserve requirement to, for example, 1 to 1 would do the trick quickly in a pinch.

Finally, the carry trade and capital migrations to foreign higher return areas of the world is continuing and it will continue and that will place large quantities of dollars in the hands of foreign central banks, which prefer to hold Treasuries as a store of value instead of those dollars. China is not the only higher return area for investment. Many other countries qualify. In his article, Success in 2010 Requires Investing in Other Countries, Roger Nusbaum makes the basic underlying point here about investment migration continuing. The market for Treasuries is not under serious pressure and if that becomes the case, the Fed will step up its quantitative easing.

Interest rates will not rise much in 2010 for these reasons -- for the same reasons they did not rise in 2009 and for the same reasons they are low in the first place.

Disclosure: no relevant positions