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Point/Counterpoint: The Case for Low Interest Rates

Published 08/14/2020, 03:09 PM
Updated 08/15/2020, 07:08 AM

By Liz Moyer and Peter Nurse -- U.S. Treasury yields soared in the middle of last week, with the yield on the benchmark 10-year note closing Wednesday at 0.761%, its highest level since early April.

These yields have slipped back since, and the trend has been lower for more than 30 years. But investors may have to start thinking about higher yields going forward. After all, how much lower can they really go?'s Liz Moyer explains why rates will stay low, while Peter Nurse offers reasons for their inevitable rise. This is Point/Counterpoint.

Low Rates Will Stay Low

Stock markets continue to climb despite a lack of evidence that the economy is making a strong comeback after Covid-19 lockdowns forced businesses to close and lay off millions of workers. There are still millions of people unemployed, though jobs have started to come back. And businesses are still struggling to rebound from the shutdowns, and many mom and pop operations face permanent closure.

In March, the Fed slashed rates to zero and took other emergency actions to try and supercharge the flailing economy. After losing nearly one-third of its value during the spring, the S&P 500 has retraced its move to approach its Feb. 19 all-time high.

Sure, interest rates are bouncing back from lows. In the mortgage market, 30-year fixed rate loans averaged a rate of 2.96% this week, up 0.08 points from the previous week. The 15-year loan average rate was 2.46% from a record low.

But something else is going on. People have been focused on the concept of negative real rates, which is what you get when you take the interest rate and factor inflation into it. During the last two months, as Barron's recently noted, the real rate of the 10-year Treasury dropped from negative 0.36% to negative 1.05%, which makes it the lowest in nearly 18 years.

Treasury data show negative real rates across the spectrum. The real rate on the five-year was negative 1.24% as of Thursday. For the 10-year, it was negative 0.96%, and or the 30-year, it was negative 0.30%. This is as reflected in the yields of Treasury Inflation Protected Securities.

The trend could explain some other phenomena in the market. Gold soared to fresh highs above $2000 in recent weeks (it gave some of that back this week). Gold is seen as a store of value, and investors may be flocking to it because it doesn't cost them money to hold, as bonds with negative rates would.

And gold's counterpart, the U.S. dollar, has fallen relative to other currencies. Negative real rates also make the dollar less attractive compared to others.

Negative rates could also help explain the rally in risk assets like stocks. If investors want to earn a return, they are better off putting their money in the stock market rather than notes at negative rates, which, again, cost money to hold.

Massive fiscal stimulus programs and bond buying by the Federal Reserve are driving rates lower. In ordinary times, this would encourage companies to make big capital expenditures. But a Covid-weakened economy means businesses are holding off on spending, the opposite of the government's goal of spurring growth.

Richard Koss, an economist and the chief research officer at New York mortgage data fintech firm Recursion, explains that the virus is a supply shock, which is unsettling the natural order of things. Car sales are down over last year while car prices are up, for example. Supply chains are messed up.

The economy is undergoing secular shifts like working from home and e-commerce "we can barely start to understand," Koss says. "Huge adjustments have to be made to the new era, and transitioning to the new resilient world will be costly."

That "doesn't support a big increase in yields."

Low Rates are Set to Rise

Last week's move up in yields was driven by both repositioning ahead of big issuance this week and a sense that the U.S. recovery is broadening and looking more robust, said NAB strategist Rodrigo Catril, in a note to investors earlier this week.

"That is reflected in the rotation in equities into more cyclical sectors and plays into the idea that U.S. Treasury yields should be higher, reflecting that improvement in prospects for the global recovery," he said.

This week saw better-than-expected employment data and increased supply with a massive $112 billion debt sale.

Hefty auctions will become regular occurrences given the U.S. budget deficit climbed to $2.81 trillion in the first 10 months of the budget year, the Treasury Department said Wednesday, exceeding any on record. This deficit has to be financed somehow.

Similarly, solid employment news continued Thursday with the number of Americans seeking jobless benefits dropping below one million last week for the first time since the start of the Covid-19 pandemic in the United States.

In a separate report on Thursday, import prices increased 0.7% in July, driven by higher costs for fuel. This follows sharply on the heels of data this week showing consumer and producer prices accelerated in July, dispelling fears of deflation.

While the slowdown is by no means over and the employment situation could still get worse given the renewed lockdowns imposed in a number of states on the back of the second wave of the coronavirus, the Federal Reserve must be encouraged by the latest economic data.

And there’s still the potential for the political impasse in Washington to be overcome and another stimulus program launched.

That may not look likely at the minute, with both sides seemingly preferring to play the blame game rather than make any serious moves to break the deadlock. But neither will want to go into the election campaign running the risk of being blamed for the continued pain in U.S. households.

A number of Fed speakers have tried recently to impress upon the policymakers of the need for more fiscal largesse, hoping Congress will do more of the heavy lifting.

Talk of negative interest rates at the next meeting of the Federal Open Market Committee, in the middle of September, has largely disappeared, with Chair Jerome Powell dismissing the possibility on a number of occasions.

That said, the central bank could seek to depress longer-term rates to keep borrowing costs cheap as the U.S. continues to work its way through recovery. It could do that either through forward guidance (by stating its intention to keep rates near-zero until inflation or unemployment reaches certain targets) or yield curve control (where the Fed purchases Treasuries until bond yields are below a stated level). 

The Fed chose not to do so in July. Deciding not to do so in September would likely result in yields rising across the board.

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