- The Washington Times - Friday, June 5, 2009

OPINION/ANALYSIS:

While the overall stock market continues its upward movement, investor conversation has begun to focus on other things that have also experienced upward movement.

While such a direction in the S&P 500 is welcomed, similar moves in interest rates are not. At the most basic level, interest rates indicate the price at which a person, company or other institution can borrow money, for periods varying from three months to 30 years. While a number of factors can affect interest rates — from supply and demand to inflation and the strength of the economy — the rise in interest rates in the last three months is starting to fuel investor concern over the current economic environment.

Why is there concern? To the average person, an increase in interest rates would seem like a good thing as it leads to better returns on cash investments in money market and savings accounts. That said, not everyone benefits when interest rates move higher. One clear example is investors in bonds, as fixed-income securities tend to fall in price as interest rates rise. Why? Because bond buyers won’t pay as much for an existing bond with a fixed interest rate of, say, 5 percent, as they would for a new one that is paying an interest rate higher than 5 percent.

Perhaps an example that more people can relate to is interest rates on bank loans. If the demand for this type of credit increases, so do interest rates, as the sellers (in this case, a bank) can command better prices (in this case, higher rates) because there are more buyers. Conversely, if demand for credit declines and there are more sellers than buyers, then interest rates decline.

Aside from supply-and-demand factors, other influences on interest rates include inflation concerns and accelerating or decelerating economic growth, not to mention monetary policy. When the economy grows too strongly, the Federal Reserve increases interest rates to slow the economy down and reduce inflation. When the economy is strong, there is more demand for goods and services so the producers of those goods and services can increase prices. A strong economy therefore results in higher real estate prices, higher rents on apartments and higher mortgage rates.

In general, when there is good news, which would reflect an expanding economic environment, interest rates tend to be on the rise By comparison, a slowing economy or a recession are what we would call bad news and those periods are characterized by lower interest rates. Where we are now is an interesting time because we are getting conflicting data that, on one hand, suggests that the worst is over, and yet some economic data, such as unemployment claims, factory orders and the like suggest continued uncertainty about the timing of an economic recovery.

In terms of keeping tabs on interest rates, there are a number of them to watch and I tend to keep my eyes on only a few of them. In general, there are Treasury notes, which are two-year, five-year and 10-year intermediate-term debt instruments used by the U.S. government to finance its debt. Longer-term instruments include Treasury bonds, which the government issues for the same purpose.

The 30-year Treasury bond used to be the bellwether U.S. bond, but now most look first to the 10-year note. The yield on the Treasury’s 10-year note is a key benchmark for home mortgages and other kinds of loans including auto loans, mortgages and some corporate debt. The yield on 10-year Treasury notes has climbed to 3.6 percent, which is head and shoulders above its 52-week low of 2.1 percent, reached in December. It is that move that has fueled concern in the investment community.

If we peel back the skin of the onion that is Treasury notes and bonds, the key use of these instruments is to finance the debt of the U.S. government. The federal budget deficit approaching $2 trillion is a culprit behind the recent rise in interest rates: the greater the deficit, the more the Treasury borrows and the higher rates go. Remember that supply and demand I mentioned above? Wider deficits also give rise to inflation concerns, which, as I mentioned earlier, also help drive interest rates higher.

The underlying problem is that recent increases in interest rates could drive mortgage rates higher and increase the cost of borrowing for both businesses and the consumer. The risk is that higher interest rates torpedo an expected rebound in consumer and business spending, which would likely delay any near-term economic recovery.

The Federal Reserve has its next policy meeting on June 23-24 and I suspect many, including myself, will be waiting to hear the results. In the meantime, I will be keeping my eye on rising gas prices and weekly unemployment claims, among other economic indicators, to get a better gauge on where consumer spending is really headed.

• Chris Versace is the director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@ washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

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