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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: ild who wrote (43611)	10/17/2005 11:08:41 AM
From: ild	Read Replies (2) \| Respond to of 110194

Berson's Weekly Commentary Economic Commentary October 17, 2005 Why have long-term interest rates jumped recently? Long-term interest rates have risen over the past month, and especially over the past couple of weeks, after having been low for a while. Yields on 10-Treasury notes, for example, were close to 4.00 percent in early September -- and now they are at nearly 4.50 percent. Mortgage rates have also increased over the same period, with yields on 30-year fixed-rate mortgages (FRMs) rising from around 5.70 percent in the first week of September to a little over 6.00 percent in early October. There are two important questions that follow from this increase: (1) why have rates risen; and (2) will they continue to rise? There are three primary determinants of long-term interest rates: the overall supply and demand for funds, inflation expectations, and expected movements in short-term interest rates. Long-term rates could rise if economic growth accelerated and borrowing demands increased -- or if the supply of capital (much of it imported) fell relative to demand. There is no evidence that foreign investors have suddenly reduced their desire for dollar-denominated assets, and there is greater concern among analysts that economic growth is slowing (because of the hurricanes and energy price hikes) rather than accelerating. So, the first reason seems unlikely. Because of surging energy prices, overall inflation has climbed substantially -- with the September consumer price index (CPI) showing a 12-month increase of 4.7 percent (the fastest pace since 1991) and it is possible that this has pushed inflation expectations upward. There are a couple of ways to try to measure long-term expected inflation. One way is to look at the difference between yields on long-term Treasury inflation protected securities (TIPS) and non-inflation adjusted Treasury securities. Using either a five or ten year horizon, there is some evidence that inflation expectations have increased modestly in recent months -- with an approximately 40 basis point increase from the recent low spread in July for a five-year horizon and about 20 basis points for a 10-year horizon. Another way to measure inflation expectations is through surveys, which is what the University of Michigan's Survey of Consumers does. Although the 1-year inflation expectations jumped in the first half of October to 4.6 percent (the highest level since 1990), the five-year expectation was unchanged from September at 3.1 percent -- about 25 basis points above the average of the past six months. Both of these measures suggest that some of the recent rise in long-term interest rates has come from inflation expectations. The figure below shows inflation expectations over the past five years using both of these measures. Finally, because of the term structure of interest rates, changes in the future path of short-term rates effects the current level of long-term rates. Since changes in Federal Reserve monetary policy are one of the most important reasons for movements in short-term rates, financial market expectations for Fed policy changes can influence long-term interest rates. In early September, futures prices on federal funds suggested that by the end of 2006, the federal funds rate would increase to 4.35 percent. Currently, futures prices suggest a rate of 4.60 percent -- an increase of 25 basis points, which should have moved long-term rates up by a similar amount. Why the rise in long-term interest rates? It appears that a portion of the increase could have come from increasing inflation expectations with the rest stemming from changes in the market's expectation of monetary policy. What does this imply for future movements in long-term interest rates? If expectations for Fed policy remain stable, then this portion of the recent rise in long-term rates should not have an effect going forward. But the key may be inflation expectations, which probably have risen in recent months primarily because of higher energy prices. If inflation expectations continue to rise, then long-term rates will likely rise as well. But, if inflation expectations either stabilize or fall, then the recent rise in long-term rates may come to an end. Much of this will depend on the future course of energy prices, which most analysts expect to be downward, but there is at least some risk that they won't decline by much. If economic activity expands next year, however, then borrowing will grow as well -- putting some upward pressure on long-term interest rates. This will be a fairly quiet week for economic data, with new data on inflation and the housing market. On Monday, the New York Fed's Empire State manufacturing survey is expected to edge up to 18.0 in October -- indicating a further expansion of the manufacturing sector. On Tuesday, the producer price index (PPI) for September is projected to jump by 1.1 percent -- with the core rate rising by 0.3 percent. Also on Tuesday, the National Association of Homebuilders survey should move down to 64 in October -- still a relatively strong number historically. On Wednesday, housing starts for September are expected to slip to 1.990 million units -- with continued strong single-family activity. On Thursday, the Conference Board's index of leading economic indicators is projected to drop by 0.6 percent -- the third consecutive decline. Additionally on Thursday, initial unemployment claims are expected to fall to around 370 thousand for the week ending October 15th -- as the effects of Hurricane Katrina begin to ebb. Finally, on Thursday, the Philadelphia Fed's business outlook survey should increase to around 9.0 in September -- suggesting a pickup in activity in the Mid-Atlantic region. David W. Berson Fannie Mae Economics