Summer's Interest Rate Mystery

The end of the Spring brought an end to the Federal Reverse’s view interest rates need to positioned in a way of stimulating the economy. For most of the past few years interest rates consistently moved downward as the Federal Reserve launched an ambitious plan to prevent deflation and bring a reversal to a stagnant economy. Low interest rates helped to keep the U.S. economy afloat while the excesses of the 1990’s worked their way off. The United State economic rally last Winter brought a dramatic increase in the level of economic growth, but at the same time an unwelcome spike in inflation fueled primarily by rising commodity prices. Strong economic growth and signs of inflation convinced Alan Greenspan and Co., interest rates should be raised to reflect an economy on solid footing.

During the last three FOMC meetings, Alan Greenspan raised interest rates by a quarter point in order to bring short term interest rates to a more neutral level. The rate hikes took short term rates to 175 basis points. Despite higher short term rates, throughout the summer long term rates have unexpectedly move downward. This surprising movement in long term rates contributed to Morgan Stanley missing estimates during their latest quarterly earnings report, and has puzzled many Wall Street analysts. While some analysts may indicate the recent economic slowdown as the reason for this abnormality, a more practical explanation lies in the United States large economic imbalances.

Over the past year the United States has experienced a troubling climb in the trade deficit, with nearly every monthly reading reaching a new record. The most pronounced rise occurred early in the summer and more recent reports have reinforced the notion our trade with foreign nations is growing more unbalanced. Earlier this year economists cited an unbalanced world recovery, with Europe in particular, failing to reach their maximum growth potential for the growing trade deficit but more recently as the world economy slowed down economic imbalances have further expanded.

International banks acting on the behalf of their national governments have been snapping up U.S. government securities since the Asian economic crisis in the late 1990’s to keep their exchange rates artificially low. A strong U.S. dollar, despite economic fundamentals indicating the dollar is overvalued, has allowed Asian nations to stimulate their economy through a trade surplus with the United States. A strong dollar is fueling a drive by U.S. companies to outsource jobs overseas in order to remain competitive. Despite the argument outsourcing helps to lower prices for American consumers, which is true, the flow of American money to foreign nations help explain why this recovery has not led to a boom in employment opportunities.

Each of the past few years the U.S. trade and federal spending situations have consistently deteriorated. The recession and slow recovery combined with increased security needs following 9/11 to put pressure on the Federal Government’s finances. Ever larger U.S. government funding gaps has provided an opportunity for foreign banks to fill their unbalanced trade with our nation by purchasing U.S. government securities. Thus keeping world trade unbalanced and allowing foreign corporations and domestic outsourcers to take advantage of low cost locations in Asia for manufacturing production.

During 2004, the economic recovery picked up some steam and lead to an unexpectedly large increase in federal government receipts. A federal government budget deficit expected to approach $500 billion in 2004 has been revised downward to $375 billion. At the same time goods continue to pour in from Asian nations, especially China. The U.S. current account deficit set a record at $166 billion during the second quarter. Should the current account numbers seen during the second quarter be projected out for a full fiscal year, there is a $225 billion surplus of demand going into purchases of U.S. government securities. This demand is creating downward pressure on long term interest rates.

The last time a significant gap emerged between the U.S. federal funding needs and international trade deficits was in 2000 at the height of the dot com boom. The circumstances are slightly different this time around, but some similarities certainly should emerge over the coming months. In 2000 economic growth was peaking as the Federal Reserve aggressively increased short term rates to rein in the economy. Interest rate spreads at the time were very narrow as a result of investors recognizing inflation was not an ongoing concern despite a robust economy. It would not be unsurprising to see interest rate spreads further narrow as the Federal Reserve continues to push short term rates up. Higher short term rates should continue to be offset with a continuing demand for U.S. securities from foreign banks to keep long term lending rates near the levels they currently are. Though, investors should be complacent about holding U.S. treasury securities should persistently high oil prices push inflation levels beyond comfortable levels.

Forecasting future interest rate moves can always be a tricky guess and the long term implications are much tougher to predict. It is expected that the U.S. government’s finances will improve over the coming decade as the economic expansion gains further strength. The Federal Reserve will undoubtedly continue to gradually push short term rates upward over the course of the next year baring a prolonged weak spot or an unwelcome bout of inflation. The foreign appetite for U.S. dollars to fill international trade gaps should continue to provide stimulus to bond prices.

With foreigners currently holding about 75% of U.S. government debt, over the long term foreign banks will be forced to take more aggressive risks in order to hold down their monetary units or allow their currencies to gain in value against the dollar. There are growing signs of concern for the U.S. large economic unbalances by some Asian governments. U.S. treasury officials, who have been pushing China to revalue the yuan higher, may be pleased if China increases the yuan’s peg against the dollar by 5-10% prior to the end of this year as is being speculated by some. Should the Chinese revaluate their currency, it would not be surprising if other Asian nations follow a similar path.