Rates Likely to Remain Low As Debt Circus Continues

Posted by Barry Simson on October 17, 2011

barry_f.jpegWhen we last wrote this newsletter, we were waiting for the end of the circus in Washington to play out to see what happened to the debt ceiling.  The circus continues but we are past the initial debt ceiling act.  As you may recall, the debt ceiling was raised, there were no defaults and all the hard budget choices were left in the hands of a committee to iron out in the future.  Standard & Poor’s had enough and downgraded the U.S. to AA+.  Moody’s and Fitch both confirmed our AAA ratings.  At the same time, the budgetary crisis in Europe was in the headlines again.  Concerns about the eurozone bailing out one or more of their member countries, costs to other stakeholders, strength of their banks and control going forward are all concerns to the market.  These negotiations have been going on for more than a year now.  As the sentiment about progress in Europe turned negative, money flowed to the U.S., rates declined and people wondered if the S&P ratings downgrade meant anything.  For the moment the U.S. is on the good side of the sovereign debt default discussions.  However, markets are fickle and once they decide the risks in Europe have subsided then we could be in the cross hairs.  The takeaway is that we have too much debt, we continue to run large deficits and without some positive budgetary action we will have a crisis similar to Europe’s.

Over the past few weeks, the Federal Reserve (Fed) started “Operation Twist.”  The Fed’s last program was Quantitative Easing 2 or QE2.  It ended during August of this year and propped up asset prices.  Operation Twist is a program designed to bring down long term rates.  There are two aspects to this program.  First, they will reinvest the cash flow from their current portfolio into mortgage-backed securities.  This will help keep mortgage rates low.  Second, the Fed will sell some of its short term investments and use the proceeds to buy longer term treasuries.  It is estimated that the Fed might buy up to 90% of the longer bonds issued by the Treasury over the next year.  These purchases should act to hold long term rates down. 

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There are always consequences to programs like Operation Twist.  For instance, once QE2 was announced, some rates and commodity prices increased.  Talk of deflation ceased and there was some increase in inflation.  We as consumers had to put up with higher gasoline prices for year partly due to this program.  With Operation Twist there are a number of results we are likely to see.  Mortgage rates will continue to be held down.  It is a good time to be a borrower if you have good credit, some home equity and the patience to go through all the regulatory mandated hurdles to get a mortgage loan.  Holding rates low and allowing consumers to refinance leaves them with more cash to spend which may help the economy.  However, savers or those who live off the interest on their investments will continue to be hurt as savings rates and bond yields remain very low.  Some community banks are likely to have problems with rates held so low.  New loans will yield between 3 and 4.5%.  Yet some branch networks cost 3% or more to run.  It does not leave much room to pay interest or take any loan losses.  The government is a winner here as the low rates keep the interest cost of our borrowing to fund the deficit low.

The other main focus of the bond market these days is the economy.  Many economists say that the odds have gone from under 25% earlier this year to over 50% now that we may move into a recession in the near future.  Even if we do not move into a recession, it may feel like one given that growth is likely to be pretty slow for a number of quarters.  Consumer sentiment and business confidence is low enough that spending by either is not going to increase economic activity significantly.   Unemployment is not going to come down quickly with or without the passage of the “jobs” bill.  Temporary jobs and tax cuts funded with permanent tax increases do not boost the economy in a way that causes businesses to expand and hire workers.  With this weakness in the economy likely to be with us for some time, the market is anticipating rates will stay low within a trading range for a period of time.