Three Reasons Interest Rates Are Heading Higher

News flash: Interest rates are close to zero. This means that they have nowhere to go but up, right? The answer is surely yes, but the next question is when? In 2001 the federal funds rate was as high as 6.50% and even as recently as 2007 it was over 5.00%. For savers, 7% rates on CDs and 6% rates on money market accounts and savings accounts were available from banks. Today, we get excited about any deposit rates over 3.00%. Nevertheless, there are signs that interest rates could be heading higher. Savers should start paying attention again to interest rates and here are three reasons why:

 

Government Debt
The United States government has been spending money at a rapid pace. Bailouts, TARP, and Obama's new budget inititiaves have all increased the government's spending. We finance our ever-increasing spending through the issuance of debt, chiefly United States Treasury securities. Investors buy our debt because of the perceived safety of Treasury bills, notes, and bonds. Foreign nations like China and Japan are some of the primary holders of U.S. debt even with the yields on Treasuries very low.

In 2009 this system of debt issuance is nearing a breaking point. The supply of Treasury securities is starting to outpace the demand for them. The Federal Reserve has a become a buyer of Treasury bonds, but even the Fed cannot solve the supply vs demand question. Economic principles suggest that yields on Treasury securities, particularly longer-term bonds, will have to increase to attract new buyers. Actually this has already started. Yields on the 10-year Treasury bond have increased from under 2.50% to over 3.20% and yields on the 30-year Treasury bond have increased from under 2.50% to over 4.00%. These are already big jumps in yields, but they may just be the beginning if the supply of Treasuries remains high.

 

Inflation
It is strange to be talking about inflation when the economy is mired in a recession. Consumer prices have been falling and even energy prices are relatively low. Even so, the perfect storm for inflation may just now be starting to take form. The Fed and the White House have pumped enough money into the financial system in their combined attempts to jumpstart the economy that they recovery could be quick and sudden. Consequently, any hints of inflation could lead the Federal Reserve to increase their benchmark short-term rates. Even an increase in the target federal funds rate to 1.00% could help savers with better rates on savings accounts. The federal funds futures contracts are already trading at the Chicago Board of Trade with an implied yield of over 1.00% on the federal funds rate by mid-2010. A further indication that short-term interest rates should start to increase over the next year.

 

Federal Reserve Forecast
Federal Reserve Chairman Ben Bernanke testified before Congress earlier this week giving lawmakers a more optimistic outlook on the U.S. economy than his previous testimony. Bernanke, at a minimum, suggested that the pace of contraction may be slowing and that the U.S. economy along with the housing market may have turned a corner. Although his comments were tempered with the usual warnings, it was a far different analysis from what we have heard before from the leader of the Fed. The idea that the U.S. economy will be mired in a years-long recession or depression seems to be losing popularity amongst economists. If it happens, a shorter recession will also mean a shorter period of ultra-low interest rates. The latest Fed forecast suggests that interest rates could be increased late in 2009 or early in 2010. For savers looking for better rates on their bank deposits, this can be considered good news. 

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