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Rising Interest Rates on the Horizon


Rising interest rates are coming due to a number of factors. First, the Fed is curtailing its purchases of mortgages indicating rising interest rates are likely. Second, the sovereign debt problem continues to raise its head. Third, large investors will move their money out of bonds they have purchased with low cost money. Fourth, The Fed will signal when short-term rates will rise eventually.

The Federal Reserve stopped buying Mortgage Backed Securities (MBS) as of March 31, 2010. Is this event the beginning of rising interest rates as some analysts predict? Let’s see.

Mortgage Backed Securities

During the last year an a half, the Fed purchased $1.25 trillion of MBS, approximately 80% of the mortgage market. The purpose was to help stimulate the housing market by bring interest rates down. Before the program began, mortgage rates were above 6%. As of the end of March 2010, the 30 year fixed rate was 5.08%.

While the Fed has stopped buying Mortgage Backed Securities, it does not mean they will start to sell what they hold. Rather they will let the current portfolio roll off, collecting the interest along the way. This in itself will not cause rates to rise.

Many people believe mortgage rates are pegged to the 10-year Treasury. This is partially true. The 10-year Treasury is one factor that influences mortgage rates though other factors move mortgage rates.

The recent rise in 10-year Treasury rates influences the price of mortgages. The rising rates for Treasures create competition for money, forcing interest rates on mortgages to rise. A year ago, the 10-year Treasury rate was around 2.2 percent. Now it is pushing 4 percent. Despite intervention by the Fed, mortgage rates only fell slightly. Now that the Fed has ceased purchasing Mortgage Backed Securities, we should see rising mortgage interest rates.

Inflation expectations helped to keep mortgage rates up, even with the Fed buying so many MBSs. Fear of a further mortgage crisis also contributed to higher rates as investors did not want to be caught again holding paper that ended up worth much less. To some extent this fear remains.

Sovereign Debt Crisis

The sovereign debt problem in Greece followed by Portugal and Spain raises the fear that a new credit crisis could spread. This fear puts additional upward pressure on rates including Treasuries. The U.S. government is spending almost 50% more than it takes in. This higher spending rate requires the Treasury to auction off more notes. To entice buyers yields will need to be higher continuing the trend of the last year.

End of Cheap Money

Large investors who can borrow at very low rates are able to use this low rate money to create higher returns using leverage. These investors leverage their own money to generate low risk high returns by borrowing low cost money available through the Fed. An example might help. An investor might want to buy $1 million in bonds yielding 5.0%, providing a $50,000 annual return. This well-heeled investor puts up 15% or $150,000 in cash and borrows the remaining $850,000 at a very low rate, say Fed Funds at 0.25% plus 2% resulting in a cost to borrow of $20,250. The return on this deal is $50,000 minus $20,250 leaves $29,750 giving the investor a 20% return on their $150,000 in cash invested. This return is available to investors as long as their borrowing costs remain low.

When the Fed begins to tighten the wide yield these investors enjoyed will disappear. Moreover, as rates rise the value of the bonds will decline in price causing investors to lose their principal.

Fed Watching

However, Fed Chairman Bernanke has assured the market they will remain accommodating on interest rates for an ‘extended period of time”. As long as the Fed keeps this language in their releases, investors expect short-term rates to remain low.

Once the Fed removes the “extended period” language, the carry trade investors will sell their investments to avoid the upcoming rise in rates. Selling encourages- longer-term rates to rise even further as investors must accept a lower price for their bond investments.

Investors are playing a guessing game on when the Fed will signal they intend to raise rates. Some of the hawks on The Fed’s Foard of Governors are making statements that rates will go up sooner than many expect. Historically, many Fed watchers believe short-term interest rates were kept to low for to long causing new asset bubbles to take hold. Worries over inflation are cropping up as well.

The Bottom Line

While we do not know when short-term rates will rise, we do know that that day will come. When it does, it will change the investing environment. The investors who took advantage of the low rates will look for new places to put their money. One of the asset classes they will consider is the equity market. As investors in the stock market, we should monitor the signals the Fed offers regarding changes in interest rates.

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