Long-term interest rates this week reached their highest levels since the spring of 1997, pushed upward by continued strong demand for credit and investor expectations of further Federal Reserve action on short-term rates to slow the booming U.S. economy.
Yields on 10-year U.S. Treasury notes, which have a major influence on the rates charged on new 30-year fixed-rate home mortgages, hit 6.77 percent yesterday, up well over 2 percentage points from their low in the fall of 1998, when world financial markets were in turmoil and the economic outlook for the United States and much of the rest of the world was in great doubt.
Yields on 30-year Treasury bonds were up to 6.70 percent, but the rise was about a half-percentage point less than the increase for the notes.
Analysts said the fact that the yield on the long-term bond is less than that of the notes, which have a much shorter maturity, is the result of a combination of factors.
First, there is a significantly greater supply of new issues in the five- to 10-year range, including corporate ones, coming to market in the near future, and the borrowing demand tends to push rates up.
Second, the upcoming Treasury offers to buy back outstanding securities are likely to be focused largely on bonds. As a result, some investors have been buying bonds they think could be on the buyback list in hopes they can profit by selling them to the Treasury.
In the past, a sustained rise in long-term yields during an economic expansion often would have been a sign that investors were demanding higher returns to offset expected future increases in inflation. But the actual level of long-term rates has two components--a premium to offset the effect of inflation and a so-called real rate--and this time around many analysts and policymakers say it's the real component that has been going up.
The real component of long rates reflects a number of influences, including whether a nation is saving enough to finance its own investments in items such as new factories, equipment, stores, office buildings, homes and highways. Currently, U.S. saving falls well short of doing so, and the large gap has to be filled by attracting investment from abroad.
The level of real long-term rates is also affected by investor expectations about changes in the Federal Reserve's target for overnight interest rates, the anchor for other short rates whose level is determined in the marketplace. And right now there is an almost universal belief that the Fed will raise that target by a quarter-percentage point at the beginning of next month, with one or more additional increases to follow.
Accordingly, many analysts, though not all, think long-term rates are headed higher.
"We expect bond yields to climb even higher during the year as the Fed tightens further," David Wyss, chief economist at Standard & Poor's DRI, told his firm's clients recently. "The United States is paying a premium for borrowing money, because of the need to attract foreign funds. With European growth accelerating, interest rates there are rising, which will tend to push U.S. yields higher despite continued low inflation."
In a speech last week in New York, Fed Chairman Alan Greenspan noted the increase in real rates of interest and said it "should not be a surprise because an excess of demand [for credit] over supply ultimately comes down to planned investment exceeding saving that would be available" when the economy is operating at full employment.
"In the end, balance is achieved through higher borrowing rates. Thus, the rise in real rates should be viewed as a quite natural consequence of the pressures of heavier demands for investment capital, driven by higher perceived returns associated with technological breakthroughs and supported by a central bank intent on defusing the imbalances that would undermine the expansion," Greenspan said.
The "imbalances" to which he referred include the shrinking pool of American workers who don't have a job but are either looking for one or say they would like one, and the record U.S. trade deficit. The latter is a sort of shock absorber for the economy when labor shortages make it difficult for firms to produce significantly greater quantities of goods and shortages in the short run.
To keep those imbalances from derailing the economic expansion by spurring higher inflation is the Fed's immediate goal, according to Greenspan and other Fed officials.
A YIELD DIP
The yield on the 30-year bond has dipped below that of the 10-year note.
Yield on various Treasury securities by maturity:
10-year yield: 6.77%
30-year yield: 6.70%