Project Syndicate
US Interest Rates Will Continue to Rise
August 2013
By MARTIN FELDSTEIN
CAMBRIDGE Six months ago, I wrote that long-term interest rates in the
United States would rise, causing bond prices to fall by so much that an
investor who owned ten-year Treasury bonds would lose more from the decline
in the value of the bond than he would gain from the difference between the
bonds interest rate and the interest rates on short-term money funds or
bank deposits.
That warning has already proved to be correct. The interest rate on
ten-year Treasury bonds has risen almost a full percentage point since
February, to 2.72%, implying a loss of nearly 10% in the price of the bond.
But what of the future? The recent rise in long-term interest rates is just
the beginning of an increase that will punish investors who are seeking
extra yield by betting on long-term bonds. Given the current expected
inflation rate of 2%, the real rate on ten-year bonds is still less than
1%. Past experience implies that the real rate will rise to at least 2%,
taking the total nominal interest rate to more than 4%, even if expected
inflation remains at just 2%.
The interest rate on long-term bonds has been kept abnormally low in the
past few years by the Federal Reserves unconventional monetary policy of
buying massive amounts of Treasury bonds and other long-term assets
so-called quantitative easing (QE) and promising to keep short-term rates
low for a considerable period. Fed Chairman Ben Bernankes announcement in
May that the Fed would soon start reducing its asset purchases and end QE
in 2014 caused long-term interest rates to jump immediately. Although
Bernankes announcement has focused markets on exactly when this tapering
will begin and how rapidly it will proceed, these decisions will not affect
the increased level of rates a year or two from now.
The promise to keep the overnight interest rate low for an extended period
was intended to persuade investors that they could achieve higher returns
only by buying long-term securities, which would drive up these securities
prices and drive down their yields. But the current version of this promise
not to raise the overnight interest rate until the unemployment rate
drops below 6.5% no longer implies that short-term rates will remain low
for an extended period.
With the unemployment rate currently at 7.4% having fallen nearly a full
percentage point in the last 12 months markets can anticipate that the
6.5% threshold could be reached in 2014. And the prospect of rising
short-term rates means that investors no longer need to hold long-term
bonds to achieve a higher return over the next several years.
Although it is difficult to anticipate how high long-term interest rates
will eventually rise, the large budget deficit and the rising level of the
national debt suggest that the real rate will be higher than 2%. A higher
rate of expected inflation would also cause the total nominal rate to be
greater than 5%.
Todays investors may not recall how much interest rates rose in recent
decades. The interest rate on ten- year Treasuries increased from about 4%
in the mid-1960s to 8% in the mid-1970s and 10% in the mid-1980s. It was
only at the end of the 1970s that the Fed, under its new chairman, Paul
Volcker, tightened monetary policy and caused inflation to fall. But, even
after disinflation in the mid-1980s, long-term interest rates remained
relatively high. In 1985, the interest rate on ten-year Treasury bonds was
10%, even though inflation had declined to less than 4%.
The greatest risk to bond holders is that inflation will rise again,
pushing up the interest rate on long- term bonds. History shows that rising
inflation is eventually followed by higher nominal interest rates. It may
therefore be tempting to invest in inflation-indexed bonds, which adjust
both principal and interest payments to offset the effects of changes in
price growth. But the protection against inflation does not prevent a loss
of value if real interest rates rise, depressing the value of the bonds.
The relatively low interest rates on both short-term and long-term bonds
are now causing both individual investors and institutional fund managers
to assume duration risk and credit-quality risk in the hope of achieving
higher returns. That was the same risk strategy that preceded the financial
crisis in 2008. Investors need to recognize that reaching for yield could
end very badly yet again.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of
President Ronald Reagan's Council of Economic Advisers and is former
President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2013
Received on Wed Aug 28 2013 - 13:23:57 EDT
