Rates Rising?

September 24, 2004

There seems to be an interesting battle developing between the Federal Reserve and the bond market. The Fed just raised short term rates to 1.75% after determining that the economy is beginning to recover. Bond yields, however, are falling to new lows on a lack of inflation fears. So what does this flattening of the yield curve mean for the US economy? Possibly trouble. By flattening the curve, the markets are making long-term investment in US treasuries less attractive. Why get 4% over 10 years when you can get almost 2% over 3 months? This is a big problem for the US, since much of what's preventing the dollar from sliding is the heavy buying of US bonds by overseas investors, primarily the Chinese. As long term interest rates decline, foreign buyers will become increasingly dissatisfied with low returns, and increasingly wary of potential losses they would take if the dollar did significantly decline. Thus, demand for long term bonds decreases, forcing the Treasury department to sell more cheap bonds, which causes them to fall in value, which causes interest rates to rise, which causes inflation, which causes the dollar to drop, which forces down demand for US treasury bonds...

Certainly it's not yet time to panic. As long as demand for bonds at the weekly Treasury actions remains strong, the dollar should stay stable. However, the flattening of the yield curve would certainly make some investors think twice about the benefits of investing in US bonds long-term.