Listen to Mom When Weighing Interest Rate Gap

The yawning gap between short-term and long-term interest rates suggests that something’s got to give soon--either long rates have to fall, or short rates have to rise.

As your mom used to say when she wanted to force you into a decision, “You can’t have it both ways!”

Well, maybe not forever. But some experts now are warning investors that the rate gap will get even wider this summer, before narrowing later.

The spread between short and long rates hasn’t been this huge since 1987. As the accompanying chart shows, five-year Treasury notes now yield 7.8%. That’s nearly 2.5 percentage points above the rate on three-month Treasury bills, at 5.4%.

Just last August, the spread between those two investments was just 1.2 percentage points.

If you’re willing to consider even longer-term bonds--say, a 30-year Treasury bond yielding 8.33%--the bonus compared to short-term rates is nearly three percentage points. No small change.

Normally, short and long rates run much closer together. “The market only gets to this kind of juncture every three or four years,” says Edward Taber III, a managing director of mutual fund firm T. Rowe Price Associates in Baltimore and the head of its taxable-bond division.

What’s occurring is a tug-of-war between the Federal Reserve, which controls short rates, and professional bond investors, who determine long rates. The Fed has pushed short rates down sharply to get the economy moving again. But bond investors, terrified by the U.S. Treasury’s mammoth borrowing needs and by fear of inflation returning, still are demanding high long-term rates, though less than what they got last fall.

Many analysts believe that long rates finally will tumble this summer, as the economy remains weak (and with it inflation). The bulls also believe that investors will pour into long-term bonds as short rates slide further. Money market mutual fund yields, the bulls note, are at their lowest level in five years--a seven-day average yield of 5.6%.

So what’s wrong with this lower-long-rates scenario? Taber just believes that too many people are counting on it. “Everybody’s long (in their portfolios) already, yet they’re expecting rates to fall,” he says. Look at the trouble the market has had digesting last week’s record $37 billion in new T-bond sales, Taber says. Peer out over the next few quarters, he notes, and “the Treasury (borrowing) calendar is just humongous.”

Taber expects long rates to rise over the next six months rather than fall, to as high as 8.75% on the 30-year T-bond, from 8.33% now. That should happen, he says, even if short rates fall anew.

And the odds that the Fed will push short rates lower are very good indeed. David Hale, economist at Kemper Financial Services in Chicago, notes that over the past 70 years, there have been only nine times when the Fed has cut its key short-term discount rate three times in a row. And in eight of those nine instances, he says, the rate was also cut a fourth time.

If Taber and Hale both are right, then, the gulf between short and long rates will grow, even though they already are oceans apart.

Of course, there are lots of dissenters. C. Frazier Evans, economist at Colonial Mutual Funds in Boston, still believes long rates will slide soon, as investors worldwide realize that inflation is under control and that economic growth is slowing even in countries that have so far escaped recession (such as Germany and Japan). He sees the 30-year T-bond yield at 7.5% by year’s end.

What’s an investor to do? Look at the big picture: Even if Taber is right, and long Treasury rates jump to 8.75%, you’re not very far from there right now. And on a shorter-term bond, such as five-year T-notes, yields have bounced just between 7.5% and 7.8% since December.

Point is, long-term rates really aren’t moving up or down that much, when you think about it. But they are substantially above short-term rates, and that’s likely to be the case at least into 1992. And to gaze out over the next five years, many experts, Taber included, see the trend of the last decade continuing: lower rates, hiccups notwithstanding.

If much of your capital is sitting in money funds earning 5.6% or less, don’t be afraid to move some cash to longer-term accounts. Almost every major mutual fund family can offer you a range of Treasury bond funds; some buy one- to five-year bonds, others five- to 10-year securities, and still others invest very long term.

Just don’t throw all of your money into the longest-term securities (where the risk is greatest), and don’t invest all at once: Ease out of cash and into better-yielding securities over the next six months. If rates do indeed bump higher in that period, you’ll ride the wave up.