Conflict May Mark a Bottom for Rates
March 2003 may be remembered for more than the start of the U.S.-Iraq war. It also may mark the final bottom for interest rates -- ending the long-term decline that began 21 years ago.
That possibility was a key point of discussion last week on Wall Street, as yields on Treasury securities rocketed amid the initial U.S. successes in the military campaign.
The yield on the 10-year Treasury note, a benchmark for rates on mortgages and other long-term securities, ended Friday at 4.10%, up more than half a point from the four-decade low of 3.56% reached March 10.
Several factors were behind the dramatic rebound in rates, but underlying it all was a growing sense that the war would go well, and quickly, for the United States and its allies. If that’s the case, the near-term economic outlook could improve considerably.
In a better economy, stocks naturally would attract more money -- and so they did last week. As some big investors cashed out of low-yielding bonds in favor of stocks, the Dow industrials soared 8.4% for the week to a two-month high of 8,521.97 by Friday.
Fast turnabouts are nothing new for markets. Trigger-happy institutional investors such as hedge funds make their living creating, and playing, short-term trends. If the war bogs down, stock and bond markets could rapidly reverse last week’s shifts.
Still, interest rates had to bottom for good at some point. Has that day come and gone, with the Iraq war as the catalyst?
One bond market veteran who thinks that may be the case is Jack Malvey, chief fixed- income strategist at brokerage Lehman Bros. in New York.
Treasury yields are unlikely to rise in a straight line from here, he said. “But by year’s end I’m figuring that rates will be higher than they are now” as the economy picks up, Malvey said.
Higher rates could, of course, have major implications for the housing market, and for investors who aren’t prepared to see the worth of older, lower-yielding bonds they own decline in value.
Some analysts have been arguing for months that the Treasury market was living in a fantasy world, albeit one the Federal Reserve helped create.
The central bank in November cut the target for its benchmark short-term interest rate half a point, to a 41-year low of 1.25%. The Fed was afraid that the economy was threatening to head back into recession. Another downturn, policymakers feared, could unleash devastating deflationary forces similar to those Japan has been struggling unsuccessfully to defeat.
The Fed’s willingness to cut rates in November encouraged many on Wall Street to believe that the central bank could do so again. As the countdown to war began, fueling fresh concerns about the economy, institutional investors sought the relative safety of Treasury securities even though yields were already paltry. If the Fed were to lower its key rate again, the rally in Treasury issues could easily continue, big investors calculated.
Meanwhile, small investors also have been heavy buyers of Treasury securities in recent months, especially via mutual funds. As stock prices fell into the red for a fourth straight calendar year, many individual investors saw that bonds were continuing to perform well. So why not keep pumping money into that asset class?
The argument against Treasury securities was that yields had reached levels that reflected an incredibly gloomy long-term view of the economy and the stock market. If investors were to become even marginally more optimistic, some bond bears said, there was only one direction for Treasury yields: up.
Malvey and others who believe that rates probably have bottomed caution that they don’t expect a huge spike from here. Indeed, the Fed is widely expected to keep its rate where it is, at 1.25%, into 2004, even if the economy strengthens.
Though the Fed directly controls short-term rates, its control over long-term rates, such as on 10-year T-notes and mortgage rates, is indirect. The marketplace pretty much sets long-term rates, based primarily on inflation expectations.
The rate of inflation has been declining for two decades -- which is why interest rates too have been declining. If inflation is bottoming, that would lend more credence to the idea that rates can’t fall further.
On the other hand, if inflation goes lower -- or turns into widespread deflation, meaning falling prices -- then Treasury yields and other rates could see lower lows ahead. Investors would be happy with meager yields as an alternative to stocks, which probably would be plummeting amid falling corporate earnings in a world where pricing pressures on businesses became more severe.
The inflation-deflation debate continues to rage, because the data are mixed: On Friday the government said the consumer price index jumped 0.6% in February, the biggest gain in two years. But take out food and energy prices and the increase was just 0.1%.
Market pros who believe that interest rates may yet head lower -- or at least aren’t poised to surge -- say the deflation threat still is great. They see waning consumer spending and believe that business spending is unlikely to pick up the slack.
“I’m not convinced of the basic thesis that getting Iraq fixed takes care of the economy,” said Vic Thompson, head of global fixed-income strategy for money manager State Street Global Advisors in Boston.
The nation may hope he’s wrong. Trillions in bond investments hope he’s right.
