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Is the Rise in Interest Rates Over?
By: Dr. Charles Lieberman
Date: 6/18/2007
The bond market has recovered somewhat, after yields on 10-year Treasuries rose to 5.25%. Is the bond sell off over? It is our judgment that 10-yields should rise a bit further to roughly 5.5%, at which point they would be fairly priced relative to the cost of money and inflation. Subsequent price movements would depend on the performance of the economy.
Yields on 10-year Treasuries have been in the 4.5% to 4.75% range over the past year, while the Fed funds rate was fixed at 5.25%, required extraordinary supporting conditions. That inverted yield curve, a conundrum according to Alan Greenspan, did not represent an equilibrium condition. It required a plausible forecast of recession, supplemented by extraordinary global liquidity. That recession forecast was based on weak housing, high energy prices and whatever else could be tossed in as supporting cast. As such, it was inherently temporary. It was only a matter of time before the artificially low level of long-term interest rates stoked global economic growth to push up inflation. Indeed, growth improved in Europe, which has previously been unable to manage much more than a tepid expansion. Growth remained very robust in Asia. And despite problems in the housing sector and an inventory buildup in the auto sector, economic growth, most importantly job growth, held up quite well in the United States.
The glut of liquidity could have over-stimulated the global economy and pushed up global inflation. Preemptively, policymakers hiked interest rates around the globe, but this also drove up domestic interest rates sympathetically. Still, the forecast of recession in the U.S. was unsustainable in the face of an economy that continued to grow and expand employment. In the end, it made little sense for overnight money to yield more than riskier 10-year Treasuries. But, how much further should rates rise to establish a lasting equilibrium?
Investors should earn a positive risk premium on 10-year notes over overnight money to reflect the greater risk on long-term debt. Moreover, it is long-term debt that is a better representation of the cost of capital that firms use to judge whether to finance capital investment or to price mortgage rates. With inflation running somewhere between 2% and 3%, depending on the measure of choice, a 5.5% yield can also be easily justified. Thus, some modest further rise in interest rates seems likely. This should also pose no problem for stocks, as companies report solid profits in this expanding economy.
By: Dr. Charles Lieberman
Date: 6/18/2007
The bond market has recovered somewhat, after yields on 10-year Treasuries rose to 5.25%. Is the bond sell off over? It is our judgment that 10-yields should rise a bit further to roughly 5.5%, at which point they would be fairly priced relative to the cost of money and inflation. Subsequent price movements would depend on the performance of the economy.
Yields on 10-year Treasuries have been in the 4.5% to 4.75% range over the past year, while the Fed funds rate was fixed at 5.25%, required extraordinary supporting conditions. That inverted yield curve, a conundrum according to Alan Greenspan, did not represent an equilibrium condition. It required a plausible forecast of recession, supplemented by extraordinary global liquidity. That recession forecast was based on weak housing, high energy prices and whatever else could be tossed in as supporting cast. As such, it was inherently temporary. It was only a matter of time before the artificially low level of long-term interest rates stoked global economic growth to push up inflation. Indeed, growth improved in Europe, which has previously been unable to manage much more than a tepid expansion. Growth remained very robust in Asia. And despite problems in the housing sector and an inventory buildup in the auto sector, economic growth, most importantly job growth, held up quite well in the United States.
The glut of liquidity could have over-stimulated the global economy and pushed up global inflation. Preemptively, policymakers hiked interest rates around the globe, but this also drove up domestic interest rates sympathetically. Still, the forecast of recession in the U.S. was unsustainable in the face of an economy that continued to grow and expand employment. In the end, it made little sense for overnight money to yield more than riskier 10-year Treasuries. But, how much further should rates rise to establish a lasting equilibrium?
Investors should earn a positive risk premium on 10-year notes over overnight money to reflect the greater risk on long-term debt. Moreover, it is long-term debt that is a better representation of the cost of capital that firms use to judge whether to finance capital investment or to price mortgage rates. With inflation running somewhere between 2% and 3%, depending on the measure of choice, a 5.5% yield can also be easily justified. Thus, some modest further rise in interest rates seems likely. This should also pose no problem for stocks, as companies report solid profits in this expanding economy.
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