Column by Jim Flinchum, CIMA, CFP - The Virginian-Pilot, November 5, 2006

For three years, most economists have confidently predicted long-term interest rates would rise. After all, the Federal Reserve Board has now raised the Fed funds rate 17 times. This spring, long-term rates finally began their “inevitable” rise. Mortgage rates increased, and the housing market stumbled.

Since then, long-term rates have been falling. More ominously, long-term rates are now slightly lower than short-term rates. Typically, long-term rates are 2 to 3 percent higher than short-term rates. The current situation, very uncommon, is called an “inverted yield curve.” Some believe this suggests a recession ahead.

Why have long-term rates dropped so much, and not just in the United States but worldwide?

Keep in mind that the Fed has some control of short-term rates but only minimal control of long-term rates. Long-term rates are determined by the “market” or supply and demand for longterm funds. Usually, during an economic recovery, the demand for long-term money increases, which increases the price or interest rate of that money. This is the main reason economists have been predicting an increase in long-term rates. Because longterm rates have now fallen, the bond market is probably telling us that the economy is softening, as if we didn’t already know.

The most widely reported increase in the supply of longterm funds is the purchase of U.S. Treasury bonds by foreigners, up 33 percent. They were buying 3 percent of our bond reopenings and are now buying 4 percent – hardly enough to justify hand-wringing in a $25 trillion global market for dollar-denominated bonds. More importantly, this still doesn’t explain why rates have fallen worldwide. A more likely reason is the globalization of financial markets, with improved transparency and easier transfer of funds between nations. It has never been so easy to match savers in one nation with borrowers in another. This also makes the Fed and other central banks less relevant.

Fed Chairman Ben Bernanke believes low rates are due to a “global savings glut,” or too much saving by consumers in nations with an inability to absorb so much capital. As a result of globalization, other nations are making more money and saving more than their capital markets can absorb, thus increasing the supply of funds available worldwide.

Bernanke also believes that long-term rates will remain low as long as the Fed controls inflation. In freshman economics, we simplistically teach that long-term rates equal short-term rates plus an inflation premium plus a credit risk premium.

Although increasing inflation also has been predicted for several years, it still is not apparent. To the contrary, inflation has dramatically decreased from 5 to 2 percent in developed countries and decreased from 14.5 percent to 4.5 percent in emerging countries. This reduces the inflation premium.

Another interesting possible explanation of low long-term rates is a relatively new type of derivative called “credit default swaps,” which is the fastestgrowing part of the $270 trillion market for derivatives. Growing 125 percent in 2004 and another 105 percent last year, contract buyers pay an annual fee – usually to hedge funds – but are guaranteed repayment of the debt amount if the borrower defaults. A huge amount of credit risk has been transferred from lenders or bondholders. This reduces the credit risk premium.

If the inflation and credit risk premiums are reduced, then the difference between long rates and short rates is reduced. This suggests that long rates likely are to remain low for a long time, which certainly makes it difficult for investors to build traditional “laddered” or “barbell” bond portfolios. This also suggests that all those homeowners staying awake at night, worrying about their adjustable rate mortgages, should roll over and go back to sleep.