Will Interest Rates Go Higher?
Under any normal circumstances, the Treasury yield would be higher than it is today, even if growth fell short of the economy’s potential. Its current level has little to do with the Federal Reserve Maturity Extension Program (informally, Operation Twist) and much more to do with the sovereign debt crisis in Europe. The latter has ensured strong demand for American assets, capping any rise in Treasuries. Risks of a slowdown in Mainland China may be relevant as well. If we do slide back into recession, chances are that it will follow from external factors more than domestic ones. As such, higher rates are a direct implication of a resolution to the European conundrum.
Investors and lenders who believe that risk-free rates will remain low are in the majority. There evaluation of the market bespeaks an implicit bet that Europe’s issues will remain unresolved or might even worsen before various national goals come into alignment. That is not an unreasonable view given the Continent’s political structure. Furthermore, the Fed’s new program of forecasting the target rate may have an anchoring effect upon long-term rates. Aside from discounting a durable solution to the European crisis in the near and medium terms, there is a further bet that economics and fundamentals will not lag long-term interest rate adjustments significantly once the latter do take hold. However safe we deem these gambles, there is an increasing need for them to inform the risk management equation lest they become the benefit of hindsight.
dsc@chandan.com
Sam Chandan, PhD, is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.
