Thoughts On Interest Rates

Here are some thoughts on the S&P debt downgrade as well as a discussion of interest rates.

Firstly, I don’t think that interest rates are going to be that affected at least soon. If you are an investor, it is hard to imagine that you haven’t already done your own calculations about the creditworthiness of the US government and all the other factors that affect interest rates. So for instance if you are a big bond investor, it’s hard to imagine that haven’t already analyzed the governments balance sheet and assessed the political climate – so just because one rating agency moved their credit rating of US sovereign debt from AAA to AA+, it unlikely that you would all of sudden start dumping your holdings of treasuries. So for example, if the analysts at Pimco had decided to buy and hold government bonds, I can’t imagine that they would alter their decision based on S&P having a slightly different analysis than them (Moody’s and Fitch still agree with the AAA rating).

So in the short term I don’t think we are going to get a spike in interest rates. That being said, I think this event is significant in that it sheds light onto the fact that many factors driving interest rates are going up in the long term.

Here is a list of factors that i think over the long term will put upward pressure on interest rates.

1. Fed Funds Target Rate – It’s hard to imagine that the fed can keep interest rates at 0 forever. Someday interest rates will rise back to a more normal level of 4 to 5%.

2. Inflation – Milton Friedman once famously said that “inflation is always and everywhere a monetary phenomenon”. With massive money printing through several quantitative easing programs and ultra stimulative monetary policy, it is hard to imagine that sooner or later it won’t show up as inflation. It is likely that inflation has already started to show up in higher food and energy prices.

3. Credit Premium – Although, I said the S&P downgrade wouldn’t likely affect interest rates severely in the short term – it signals that there might be a higher credit premium built into treasuries at some point. It will be interesting to track the premiums on credit default swaps that insure US government bonds. I think that the issue of demographics will be a large factor that strains government finances. There will be many more Americans eligible for social security retirement benefits as well as increased health care spending over the coming years. Over the next 20 years roughly 80 million Americans will be eligible for social security. According to the US Census, the dependency ratio measured as the percentage of people over 65 to those of working age population will rise from 22% to 38% in the next 25 years.

4. Liquidity premium – This could be a factor but only once a crisis unfolds. The treasury market will remain liquid unless there is an investor panic of sorts. This would likely result in a flight to safety to Gold.

5. The End of QE – The end of Quantitative easing means less demand and that the Fed will no longer be suppressing long term yields.

6. Foreign demand – Countries like China, Russia and Brazil have been vocal about their displeasure with the United States handling of their finances. It is unlikely that China will suddenly dump US bonds but they could just let some of it mature or diversify their investments a bit more. That could also mean lower demand.

7. Supply – More debt (more supply) since the debt deal that was passed did very little to affect the upward trend of debt, this will also put upward pressure on interest rates.

I still don’t think that interest rates are going up severely in the short term. However, i do see many long term factors that will put pressure on interest rates to rise. Just like in the last crisis, problems only started unfolding once interest rates started to rise and homeowners with adjustable rate mortgages couldn’t afford to pay the interest payments, the US government will also have much greater problems once interest rates start to rise. That will likely be a weight on the entire economy.