Rise in key borrowing rate has two interpretations

By Neil Irwin
Washington Post Staff Writer
Tuesday, April 6, 2010; A09

Long-term interest rates are rising, and the question of why has huge stakes for the economy -- and has become a Rorschach test for financial market watchers.

During the past month, the rate that the federal government must pay to borrow money for 10 years has risen steeply -- to nearly 4 percent on Monday, from 3.6 percent on March 4. That higher number is likely to drive up a wide range of other commonly used interest rates, boosting what home buyers must pay to take out a mortgage, and raising borrowing costs for companies looking to expand.

For optimists, there is a benign explanation. With the economy performing better, the Federal Reserve will eventually have to raise interest rates to stave off inflation, and in anticipation of higher future rates, long-term investors are already demanding compensation. Moreover, the strong economy is making investors confident enough to move their money into risky assets such as corporate debt from safe government bonds, creating a gush of money away from Treasury securities.

Others are more pessimistic. With public debt levels soaring around the world, the supply of bonds has begun to outstrip investors' appetite for them. Some investors may be questioning whether the United States will ever get its fiscal house in order and are demanding higher rates because the federal government seems to be a riskier borrower than in the recent past. Meanwhile, investors' expectations about inflation may edge up, leading them to require higher interest rates.

Even with the recent increase, rates remain low by any historical standard. Nonetheless, higher interest rates could be a drag on growth, particularly if increased mortgage costs stifle the nascent recovery in the housing sector.

Rates have risen during a period in which economic data have mostly exceeded expectations, underscored by the addition of 162,000 jobs in March, the best month for employment growth in three years. In the latest piece of good news, the National Association of Realtors said Monday that its index of pending home sales, a forward-looking indicator of housing activity, rose 8.2 percent in February.

Moreover, the rise in long-term rates has coincided with investors' expectations that the Fed will raise its target for short-term rates sooner rather than later. Although Fed leaders have said they expect to keep their interest-rate target very low for "an extended period," investors think there is a 45 percent chance they will raise rates by their September meeting based on trading in futures markets. A week ago, those markets were pricing in only a 35 percent chance of rate hikes.

As for the other leg of the rosy scenario -- that the rise in bond yields reflects people moving money out of safe instruments such as Treasurys and toward riskier assets -- market data also offer some confirmation. The difference in rates between government bonds and corporate bonds has narrowed over the past month, and the stock market has risen.

"This is more an outcome of a robust recovery than a risk to that recovery," said Dean Maki, chief U.S. economist at Barclays Capital.

"My view is, this rise in yields is what you expect to happen as a recovery comes together, and not something to worry a lot about," said Ethan Harris, chief economist for Bank of America-Merrill Lynch.

But even Harris and others who hold that view acknowledge that there are some reasons for angst in the recent run-up in rates.

The government auctioned $118 billion in debt last week, part of its ongoing effort to fund current budget deficits and roll over old debt that has matured. Fewer buyers than expected showed up, contributing to a steep rise in rates last week.

That suggests bond investors are coming to terms with the large needs for funding coming from the U.S. government -- and other sovereign entities -- in the near future, and are insisting on higher rates given the flood of new federal debt to be issued.

The Federal Reserve last week ended a program to buy $1.25 trillion in mortgage-backed securities, and foreign buyers have shown less interest in U.S. government debt, factors that reduce the pool of buyers for those assets and drive up interest rates.

A related but more long-term risk is that bond buyers could come to think that the government will not be able to rein in its budget deficit to a sustainable level, making investors demand more compensation because of this risk.

"You're losing some very price-inelastic demanders . . . and that's probably a little bit of what is going on with higher rates," Harris said. "Once the economy gets into full recovery, you have to figure the equilibrium rates should be higher given the structural deficit the U.S. has."

Another factor that can drive rates up is a rise in inflation expectations. After all, if investors think that a dollar in the future will be worth much less than it is now, they'll require a higher rate of return to invest their money.

But because the Treasury Department also issues debt that is adjusted for inflation, it is relatively easy to untangle whether rising inflation expectations are at work by looking at prices of the two types of bonds. That data suggest that investors expect modest inflation over the coming decade, just over 2 percent per year.

Some analysts are skeptical of the idea that fiscal fears could be a major reason for higher rates.

"I don't buy it at all," said Robert Barbera, chief economist for the Investment Technology Group. "There's been no new news about the fiscal picture. We didn't just discover that there are big budget deficits over the last 60 days. What has changed over the last 60 days is the economy is doing a hell of a lot better than expected."

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