Long-Term Interest Rates: Why You Should Care
from May/June 2003
by Rob Norton
Long-term interest rates have been a pretty reliable forecasting tool during the recent business cycle. The 10-year Treasury rate began falling way back in January 2000, more than a year before the peak in the economy (and the onset of the recession) in March 2001. Since the outlook for inflation didn’t change, the fall suggested that bond traders, unlike almost everybody else, correctly sensed that the U.S. economy was moving into a period of weakness. The long rate continued to flash a red light throughout 2001 and 2002, even as most forecasters were predicting—inaccurately, as we now know—that the economy would soon begin to recover. From January 2001 until mid-2002, yields on 10-year Treasury bonds were suspended between 41¼2% and 51¼2%.
The forecast that long-term rates have been making more recently remains bearish. In late 2002 rates began to fall even further, with the monthly average dipping below 4% in September and October and hovering just above that into the new year. Again, despite a continued belief among economic forecasters that the next expansion is just a few quarters away, long-term rates are suggesting that it may be years rather than months before the economy moves back into healthy growth.
Business strategists can find a silver lining in this gloomy outlook. For companies that are confident about their own futures, the current trough in long-term rates is a golden opportunity to raise long-term funds in the bond market. But while many companies have been taking this view, the uncertain business outlook has caused many others to hold back. After record corporate bond volume in 2001, new issues slumped last year. During 2002, corporations issued $594 billion in bonds, down more than 26% from the same period in 2001.
How long will the chance to lock in long-term financing at historically low interest rates last? Probably not too long. Many economists worry that the return of big budget deficits—$300 billion forecast for each of the next two years, with no return to a balanced budget in sight—will soon push up interest rates. But there are mixed opinions about whether and to what degree the deficits actually cause long-term rates to rise.
The basic argument that swelling budget deficits tend to raise interest rates is accepted by economists of many different political and academic persuasions. Other things being equal, if government borrowing increases significantly for an extended period, it will compete with corporate and individual borrowers for national savings. Unless the supply of savings goes up, the increased demand will lead to higher interest rates.
But as in nearly every important question about economics in the real world, other things are not equal. The market for U.S. Treasury bonds, for one thing, is open and international, so the U.S. government’s demand for new funds can be met in part by borrowing from foreigners. To the extent that happens, the effect on interest rates is not just on those in the U.S., but on world rates. Big as the U.S. government’s borrowing needs may be, they have much less impact on interest rates in the global economy than they would if they were confined to the U.S. economy.
Another reason deficits may not increase rates as much as the textbooks suggest is that the tax cuts and increased government spending that push the budget into the red can also stimulate the economy. In that event, the effects of rising incomes, savings, and tax collections may offset part of the damage that deficits would otherwise create. Rates were high in the 1970s when deficits were small, and rates fell in the 1980s when deficits first got out of control. The recent drop in rates happened at the same time the budget moved from surplus to deficit.
The debate over the budget deficit and its impact on long-term interest rates will be long and noisy. Democratic partisans and their favorite economists will warn ominously that the deficit is sure to push long-term rates back up to economy-threatening levels any day now; their Republican counterparts will insist that deficits have no ill effects whatsoever. Treat all these arguments with skepticism. What’s most likely is that there will be some modest upward pressure on long-term rates if the deficit outlook continues to worsen.
Far more certain is that long-term interest rates will begin to rise as soon as the markets become convinced that the economy is poised to move into another strong period of expansion. That will be much more important news for the American economy than the fiscal wrangling in Washington. In the meantime, any company that envisions expanding its business at some point over the next decade would be well advised to go to the bond market now, while the current “sale” on long-term funds is still under way.
