Another weird conundrum. Long term interest rates are normally expected to be higher than short term interest rates to compensate investors for the higher risks involved. However the recent phenomena of rising short term interest rates and falling long term bond yields has many Wall Street honchos and even the legendary, Alan Greenspan baffled. Read on to find out why?
Long-Term Interest Rates Buck Conventional Wisdom By Tom Petruno Los Angeles Times | 10 June, 2005 http://www.latimes.com/business/la-fi-rates10jun10,0,4694398.story? coll==la-home-headlines The surest bet on Wall Street a year ago was that long-term interest rates would rise, boosting the cost of home mortgages and in general making credit tougher to get. That forecast seemed to make perfect sense because the Federal Reserve was raising its bellwether short-term rate for the first time since 2000. Long-term rates usually move in tandem. But that sure bet has been a big bust: To the shock of most investment pros as well as the Fed � and to the relief of home buyers � long-term rates have tumbled, even as the Fed has raised its key rate eight times over the last year, from 1% to 3%. While the housing market celebrates the good news of 30-year mortgage rates under 5.6%, down from 6.3% a year ago, a lot of financial professionals have egg on their faces. "Basically, 100% of economists have gotten the direction of long- term interest rates wrong," said Steven Permut, a money manager at American Century Investments in Mountain View, Calif. Now, a new school of thought is developing among market analysts. Some believe long-term rates could hold at current levels for years, or even fall further to low single digits. In a world awash in savings, investors' urgency to lock in returns on fixed-rate, long- term IOUs like bonds will help keep a lid on rates in general, they say. Bill Gross, chief investment officer at Newport Beach-based Pacific Investment Management Co. and one of the world's top authorities on interest rates, says it's conceivable that the rate on the 10-year U.S. Treasury note, a benchmark for mortgages and other long-term interest rates, could drop to 3% in the next three to five years. Currently it's just under 4%. If he's right, that could mean that far lower mortgage rates lie ahead � which could provide a bailout for people who have purchased homes with huge, interest-only loans and are hoping to eventually refinance with more favorable terms. Some experts, however, say Wall Street is taking a familiar tack: Tired of being beaten by the market for so long, more analysts now are joining it. "We're probably reaching a point where everyone just throws in the towel" on the idea of higher long-term interest rates, said Michael Darda, an economist at investment firm MKM Partners in Greenwich, Conn. But that kind of capitulation often signals the end of the very trend that investors are jumping aboard, he said. Recent history provides a glaring example, Darda said. In the first few months of 2000, after two years of spectacular gains in technology stocks, many investors who had avoided the shares in 1998 and 1999 were scrambling to get in at any price. That proved to be the zenith for the tech mania. For its part, the Federal Reserve says it can't explain why interest rates have diverged. In testimony before Congress' Joint Economic Committee on Thursday, Fed Chairman Alan Greenspan said "something unusual is clearly at play here" � repeating a view he has had since February, when he called the decline in long-term rates a "conundrum." The Fed, as the nation's central bank, controls short-term interest rates by changing the so-called federal funds rate, or what commercial banks charge each other for overnight loans. Historically, the Fed has raised that rate when it wanted to slow the economy, usually because inflation pressures were building. And when the Fed is lifting its key rate, long-term rates typically rise as well. But the Fed doesn't directly control long-term rates. They are set in the marketplace � for example, by the level of interest investors demand on government bonds. The annualized yield, or interest rate, on the 10-year Treasury note was as high as 4.87% a year ago, just before the Fed began raising its short-term rate from a four-decade low of 1% to the current 3%. On Thursday, the yield on the Treasury note was nearly a full percentage point lower, at 3.95%. What's more, the downtrend in long-term rates has been a global phenomenon. Government bond yields have fallen to generational lows this spring in major European economies such as Germany and minor ones such as Lithuania and Estonia. In Japan, long the home of the world's lowest interest rates, the yield on the government's 10-year bond is at 1.23%, down from 1.78% a year ago. It isn't just government bond yields that have plummeted. High-risk companies that borrow via so-called junk bonds also are paying less today for money than a year ago. Stephen Roach, an economist at brokerage Morgan Stanley in New York, had been expecting U.S. long-term rates to rise this year. But last month he changed his forecast. "I now suspect bond yields will stay low for the foreseeable future," he said. He cites, in part, the continuing hunger many investors � and speculators � have shown worldwide for bonds. As more people step up to buy, the effect is to allow governments and other bond issuers to pay less on their IOUs. That drives other long-term rates lower as well. And because the world economy continues to expand, there is plenty of wealth around looking for a place to go, economists say. Nations such as China, which have huge trade surpluses with the U.S. but no significant bond markets of their own, have funneled large chunks of their savings into U.S. and other foreign securities. Roach believes the desire to lock in fixed-rate returns on bonds also reflects a more cautious global attitude about risk taking, especially in the stock market. "With the days of heady, late-1990s-style returns on equities long thought to be over, fixed-income investments have become the new asset class of choice," he said. A Merrill Lynch & Co. survey of the world's millionaires, issued Thursday, showed that they on average had 27% of their financial assets in bonds last year, up from 25% in 2003. By contrast, the percentage of assets held in stocks slipped to 34% from 35%. Aging baby boomers in the U.S. and elsewhere in the world also are a natural and growing audience for fixed-income securities, analysts say, because people generally shift toward more conservative investments as they get older. But discussions about why money is flowing into long-term bonds often ignore the logical motivation, some analysts say: Investors, they say, must believe that the economy is slowing enough to mean the Fed is almost finished tightening credit. If the Fed indeed is nearly done raising short-term rates, it wouldn't be unusual for long-term interest rates to be falling. Investors usually anticipate peaks in short rates and peaks in the economy and rush to lock in more attractive returns on the assumption that all interest rates soon will head lower, said David Rosenberg, an economist at Merrill Lynch. He believes the economy will be weak enough by 2006 for the Fed to begin cutting rates again. Likewise, some experts who see lower long-term rates in the years ahead warn that they would most likely be accompanied by disappointing economic growth, which could mean poor returns on other investments, such as stocks, and a tough environment for job seekers. Some money managers, such as Pacific Investment's Gross, favor relatively safe government bonds in their portfolios in large part because they fear what could go wrong in global markets in the next few years � especially with institutional investors increasingly pouring cash into hedge funds that pursue risky investment strategies using borrowed money. The boom in that investing style means "more systemic, systemwide risk," Gross said. Greenspan on Thursday acknowledged the risks inherent in certain "imbalances," including the nation's mammoth trade and budget deficits. Yet he remained upbeat on the economy overall. "The hypothesis that it is a weak world economy which has been driving down long-term interest rates is probably not correct," he told Congress. Still, he could not say exactly what the cause was. Moreover, he said nothing to indicate that the central bank was ready to stop raising short-term rates. David Malpass, an economist at brokerage Bear, Stearns & Co. in New York, believes that the U.S. economy is healthier than some recent data have suggested, and that stronger growth also will bring further inflation pressures � which could change the sanguine outlook of investors now willing to accept historically low bond yields, he said. Inflation eats away at fixed-rate returns. The Fed, Malpass said, "will have to raise rates substantially higher on evidence of growth and inflation, and bond yields will rise with them." The central bank's short-term rate could be at 4.5% by year's end, 1.5 points above the current rate, he said. Darda, the MKM Partners economist, also believes the Fed will continue to tighten credit. Someone who locks in a 10-year bond yield of 4% will be sorely disappointed if new bonds are paying 5% by year-end, he said. Just because long-term interest rates have stayed remarkably tame over the last two years doesn't mean that can go on forever, Darda said. Many investors in the late 1990s became convinced that tech stocks would never fall significantly, he noted. Now, as then, "people are making up crazy theories to justify the unjustifiable," he said. ------------------------ Yahoo! Groups Sponsor --------------------~--> Has someone you know been affected by illness or disease? Network for Good is THE place to support health awareness efforts! http://us.click.yahoo.com/RzSHvD/UOnJAA/79vVAA/NJYolB/TM --------------------------------------------------------------------~-> �������������������������������������������������������� This is ZESTEconomics. Post economics-related articles and event info to [email protected] If you got this mail as a forward, subscribe to ZESTEconomics by sending a blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! 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