Federal Reserve & Interest Rates

With increasing investor sentiment that the economic recovery is gaining steam, many bond analysts are predicting a subsequent rise in Treasury yields.  Coupled with the fact that the Fed will be ending it’s program to purchase up to $300 billion in Treasuries sometime in October, there is a general feeling that yields have no where to go but up.

We likely going to see more and more investors leaving the safe haven of Treasuries and seeking higher returns in the next few months.  The Fed is still expected to keep it’s targeted Federal Funds rate at between 0% and .25% when it meets this week.

As talk of the government’s exit strategy also gains steam we are also likely to see traders start to price in future Fed rate hikes, although that’s still premature at this time.  Based on futures options most investors believe the Fed will keep rates at their current level at least until next summer or fall.

However, unless the economy starts to falter once again, the forces behind higher yields are likely to gain in strength over the next few months.  There’s going to be a lot of Treasury supply coming down the pipe for an extended period of time, especially with government projections that the national debt will likely double once again in the next decade.

Calls for an end to the recession are gaining steam once again and the Federal Reserve should be watching carefully how investors react.  The huge increase in government debt has had little impact on interest rates so far, since many investors are still using Treasuries as a safe haven until they think the markets are starting to turn around.

Many investors are champing at the bit, hoping better yields are around the corner and the big question is where will they turn to, stocks or commodities.  If we start seeing a big push in commodities once again, the Fed will have to rethink it plans to keep interest rates at 0% for an extended period of time.

A lot will depend on the next earnings reporting period, if those numbers remain sluggish, investors may view commodities as the better option.  Keep in mind that the government’s debt is one big noose hanging around our economy and while inflation concerns are muted for the time being, eventually it’s going to rear it’s ugly head.

As investors start turning away from Treasury securities those inflation concerns will start growing.  If the Fed has to raise rates before they want to, it could have a serious impact on recovery efforts.

Demand isn’t going to remain down forever but it’s not going to return to it’s former level overnight, not with the current unemployment situation the way it is.  That being said, the Fed is going to have some difficult choices ahead of it pretty soon.

Many experts believe that this recession is going to leave a deep and lasting impression on the economy through the next decade.  Economic growth will likely remain sluggish for years to come and the availability of credit will also remain scarce for some time as the banking system tries regain it’s footing.

Although we’ve already seen the U.S. government pump trillions into the financial system to prevent it from collapsing, it is by no means out of danger.  Unfortunately, financial markets will most likely be in a precarious position for many years to come.

Investors have already shown some concern over the long term implications of the government’s massive debt load and in the past month yields on 10 year Treasury Securities have started to rise.  Despite the fact that global demand is weak and is expected to remain that way for some time, we have also seen commodities markets start to creep up as well.

Inflation concerns will likely hound the U.S. financial market for years to come.  It can’t hide from the fact that Treasury yields will most likely rise in order for the U.S. to fund it’s financial recovery plan.

This will have a spillover effect on consumer interest rates and will affect bond markets for years to come.  The primary weapon to fight inflation is to raise interest rates but while that may keep inflation in check, it also serves as a severe handicap to economic growth.

There are no free lunches, so while the government’s massive intervention may have kept it from collapse in the short term, that same intervention will most likely keep it in a weakened state for quite some time.  For now the dollar has kept it’s place as a reserve currency for the rest of the world but how long that will be the case remains to be seen.

The next few years will be very important, the severe debt load of the U.S. government was already a problem before the recent massive increase and will have to be dealt with sooner rather than later.  While technically the funds the government used to save the financial system were loans and are expected to be paid back, they face a significant risk of losses due to defaults.

A number of federal agencies with the Federal Reserve and the Treasury at the forefront, will face a difficult balancing act over the next few years in order to maintain the stability of inflation and interest rates and it’s overall effect on economic growth and the financial system.