In theory, bond investors are supposed to keep the behavior of governments and consumers in check by passing judgment on a nation's fiscal health. If things look bad, they sell, pushing up interest rates, and forcing policymakers and consumers to change course. From the outset of the financial crisis, critics warned that the combination of higher deficits (thanks to increased spending and collapsing tax revenues) and the Fed's easy money policies would ignite inflation, and act as a clarion call to the bond vigilantes.
But for two years, the bond vigilantes seemed to remain in hiding, as interest rates on U.S. government bonds generally fell, and then fell again. But in the past month, after laying waste to Greece and Ireland, the bond vigilantes have finally hit America's shores. In recent weeks, investors fearful about America's long-term financial future have pushed up the interest rate on the 10-year and 30-year bond. The yield on the 10-year bond has risen from 2.48 percent on November 4 to about 3.3 percent today -- an increase of 33 percent. Rates on other government debt have also drifted upward. SmartMoney.com's living yield curve provides an excellent month-by-month graphic on how interest rates move over time.
The swift movement raises several questions for consumers, borrowers, and policymakers.
But for two years, the bond vigilantes seemed to remain in hiding, as interest rates on U.S. government bonds generally fell, and then fell again. But in the past month, after laying waste to Greece and Ireland, the bond vigilantes have finally hit America's shores. In recent weeks, investors fearful about America's long-term financial future have pushed up the interest rate on the 10-year and 30-year bond. The yield on the 10-year bond has risen from 2.48 percent on November 4 to about 3.3 percent today -- an increase of 33 percent. Rates on other government debt have also drifted upward. SmartMoney.com's living yield curve provides an excellent month-by-month graphic on how interest rates move over time.
The swift movement raises several questions for consumers, borrowers, and policymakers.
The answer: While the Fed is enormously influential in setting interest rates, it's not the only factor. Ben Bernanke & Co. directly control the Federal Funds rate -- i.e,. the rate at which banks lend to one another on an overnight basis and that serves as a benchmark for short-term credit. The Fed Funds rate hasn't budged at all in recent months, and is unlikely to do so until the Fed decides it's ready to exit this emergency period of ultra-low interest rates. (Investors in Fed Funds rate futures predict that won't be until late 2011 at the earliest.)
But the longer the term of the debt, the less direct control the Fed has over the interest rate, and the more other factors and emotions come into play. And in recent weeks, there have been two important changes in investor psychology. First, the flow of generally positive economic data has pushed forecasters to increase their projections for growth in this quarter and next year. All things being equal, expectations of higher growth tend to push longer-term interest rates up. Meanwhile, the surprise tax deal between President Obama and Congressional Republicans has reinforced the consensus behind stronger growth for 2011 and 2012 and heightened the concern over deficits. (Deficits for the next few years will be much higher than previously thought if the deal goes through.)
Rising interest rates raise your cost of money. But not everybody is going to be paying more for money in the wake of the recent moves. BankRate.com has an excellent module that shows weekly moves in interest rates on a variety of credit products.
The most immediate impact of higher long-term government borrowing costs will be seen in the arena in which consumers borrow for the long-term: mortgages. As the chart on Bankrate shows, interest rates on 30-year mortgages have spiked in recent weeks, to near five percent. And so to the potpourri of troubling housing news -- excess supply, foreclosures, a weak job market -- we can now add higher rates. In the absence of what finance types used to refer to as "innovative mortgage products" (you know, exploding ARMs, negative amortization bombs, and other funky products), higher rates are going to make it more difficult for home sellers to get their asking prices in glutted markets. It's also bad news for home buyers, who will have to adjust their sense of how much house they can afford.
But most borrowing done by consumers and businesses is shorter-term debt. And there hasn't been quite as much movement in this area, in part because that's where the Federal Reserve is focusing much of its latest round of buying. The New York Fed, which is charged with carrying out the program of quantitative easing, announced in November that 63 percent of its new purchases would be of bonds that mature in 2.5-7 years, while only 6 percent of purchases would be of bonds that mature in 10 or more years. "Under this distribution, the Desk anticipates that the assets purchased will have an average duration of between 5 and 6 years."
And so even though bond markets broadly expect higher interest rates, there's been less movement in the rates for shorter-term credit. Bankrate.com shows that rates on auto loans are actually down slightly from the previous week. (Keep in mind: all these figures are national averages.) Home equity loans, another credit sector pegged to short-term interest rates, haven't changed much either.
For now, companies and individuals with excellent credit who want to borrow money for a few years -- from a bank, or from the bond market -- aren't finding that conditions have changed. With credit cards, there's long been a sense that the interest rates charged bear little relationship to the overall interest rate climate. Individual credit scores, delinquency and charge off rates, the need of banks to goose profits, and their relative level of aggression can all be more powerful influencing factors on credit card rates than the shape of the yield curve. The New York Times reported Monday, for example, that credit card companies are again pursuing more risky borrowers. For what it's worth, Bankrate.com says credit card rates were essentially stable during November.
As noted, the shortest-term rates haven't budged much at all. Which means that you and I will continue to lend money to banks at extremely low rates. In the weeks since the bond market rout started, rates on one-year certificates of deposit have actually fallen.
So, just as the banks are able to increase the price they charge you for long-term money, they're lowering the price they pay you for short-term cash. Somehow, the banks always seem to win.
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