Higher Interest Rates Ahead

April/08/2010 16:28PM
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Despite the best efforts of our government, interest rates in the US are going to rise.

The US has the largest peacetime deficit and debt/GDP ration in our history. In 2015 entitlements and interest payments will make up 71% of government expenditures. The government can’t cut spending and must change entitlements. The current government is changing entitlements, but in the wrong direction, raising them. To reduce the US deficit to 3% by 2015, the options are: raise taxes by 15% across the board, individual taxes raised by 30%, top brackets raised to 70%, or a value added tax of 7.7%. Ms. Peloisi has made some comments lately about the last idea. Slap a Federal sales tax on everything.

Where is our $8.2 trillion on publicly tradable U.S. Federal Debt? In Central banks and public/private entities outside the US. Is the demand for US treasuries dropping? Not yet. But, These countries keep buying treasuries to keep their currency from inflating. If that changes, and it will, all hell could break loose.

There are some tremors. Ten year swap spreads VS. Treasuries are negative for the first time. Interest rate swaps are a $14 trillion dollar market. This could be just noise. But, given the fact that the Treasury supply is huge, this may well be a sign that it will not be absorbed at current interest rates. P&G, J&J, and Lowe’s corporate bonds have traded higher than US Treasuries in recent weeks, showing the concerns about the U.S. government are not confined to swap markets.

Here’s my read. As equities represent less risk, it takes higher interest rates to sell Treasuries. The massive US budget deficits, less demand for Treasuries, and worse relations between the U.S. and China all say interest rates are headed up. How far is the question. If they go above 5% we have big problems. The buds of the economic recovery would die quickly at that level.

The level of government spending in this country can’t be sustained, we all know that. There appears to be little interest in the current administration to curtail spending. The ability to run a country with entitlements and interest payments on loans to foreign governments running 71% is impossible. The ability to raise taxes to reduce the deficit to a reasonable level is not plausible. When corporate bonds are more attractive at lower interest rates than those backed by the Federal Government, we are in deep water.

Based on all this it seems inevitable that interest rates will rise. Despite efforts by the Fed to keep them down, less debt demand for the huge supply of Treasuries the US needs to sell will drive them up. Creditors are not stupid. The Chinese have already fired a warning shot. Bad management in the US will make us an undesirable credit risk. No teleprompter can prevent this. Our leaders are mismanaging our country. So much so that we are being seen as a poor place to loan money. If the Tea Party People can see that, one must assume sophisticated investors certainly can. Pretty sad.

What can you do? Keep you fixed income maturities short and your powder dry to take advantage of higher rates on fixed investments in the near future.

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