Are Low Interest Rates Here to Stay?
Ron DeLegge, Editor
February 24, 2010
SAN DIEGO (ETFguide.com) – The Fed’s Chairman told Congress he thinks interest rates should stay low. But just last week, the Federal Reserve did the exact opposite. They increased the discount rate or amount charged on loans made to banks. Should we believe what the Fed says or what the Fed does?
Let’s analyze if low borrowing rates are here to stay.
Impact on Bond Investors
For the past year or so, conservative bond investors have been tortured with anemic yields.
Government treasuries with 1 to 3 year maturities (NYSEArca: SHY) are yielding around 0.87%. If you think that’s low, government bonds with even shorter maturities of 3 to 6 months are yielding between 0.11% to 0.18%. Seven day yields on leading money market mutual funds are between 0.02 to 0.05%.
Low rates have caused varying reactions.
For example, some investors are snapping up higher risk bonds with longer-term maturities and questionable creditworthiness.
Bidding up Junk
“I’m more concerned about the return of my principal than the return on my principal,” stated humorist Will Rogers. Of what value is a juicy bond yield if your bond issuer defaults and can’t repay you? This is a vicious lesson, many bond investors still haven’t learned. High risk junk bonds (NYSEArca: JNK) have been bid up over the past year by 50% by eager buyers desperately seeking seductive yields. How much longer can the feast last?
One way to ensure the return of your money is not to lend it to untrustworthy borrowers. Another strategy is to diversify your single issuer credit risk by not investing in individual bonds. Bond ETFs can help you to accomplish this goal.
One last tip is this: Avoid the temptation of following the crowd by chasing bond yields. Many investors have shipwrecked themselves by exclusively concentrating on yield and throwing credit and duration risk aside.
“Do as I Do, Not as I say”
Acting Fed Chairman Ben Bernanke’s latest testimony to Congress indicates he believes a low interest rate environment is still required to get the economy back on track. Nevertheless, the Fed last week increased the discount rate it charges to banks for direct loans by one-quarter percent to 0.75%. The Fed says it wants banks to rely less on its lending facilities and to rely more on conventional methods like money market instruments.
What impact will last week’s increase of the bank discount rate have on the economy? In the Fed’s own words, “The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.” Really?!
Regardless of what the Fed publicly says, banks (NYSEArca: KBE) getting squeezed means consumers and business will probably get squeezed too. Despite unprecedented Federal intervention, bank lending in 2009 still fell to 68-year lows. Will lending miraculously improve now that the Fed is increasing rates it loans to banks?
Instead of re-affirming a low interest rate environment, the Fed’s actions seem to indicate the exact opposite. Increasing the discount rate for loans made to banks could be just the start of a new cycle of higher interest rates. It can’t be too long before the Federal Funds rate, which now sits between zero and 0.25%, is raised.
During the height of the 2008 credit crisis, the implicit trust in corporations to pay on their debt evaporated. Credit rating agencies and the safety they assigned to corporate debt and especially mortgage debt were rocked. Have these risks really diminished two years later?
Very soon, the public will get a glimpse of the real “new and improved” economy.
The first test of whether low interest rates are really here to stay will happen at the end of March. At that time, the Federal Reserve’s $1.25 trillion program to buy mortgage backed securities expires. Then, at the end of April, government programs to help troubled borrowers to stay in their homes and the $8,000 tax credit for first time homebuyers are set to expire.
“What Economic Indicators are Really Telling Us,” perfectly illustrates the error of trusting in feelings rather than facts. It also shows how trusting in the Fed’s confusing behavior leads to unwanted results.