Why Interest Rates Keep Rising, Despite QE2

The Federal Reserve hoped to keep interest rates low with its bond-buying policy, but rates have continued to climb instead.Keeping interest rates low is a linchpin of the Federal Reserve's quantitative-easing policy (QE2), a $600 billion bond-buying program aimed at stimulating the economy. The basic idea is that low rates will encourage businesses to borrow and expand -- including hiring more employees -- and will boost housing sales by making mortgages cheaper for potential homebuyers.

Unfortunately for the Fed, bond yields and interest rates having been rising since it began buying Treasury bonds as part of QE2 in the fourth quarter of 2010. And they seem likely to continue rising despite the massive intervention by the Fed. Here are some of the broader factors that are working against the U.S. central bank:

1. The Fed's policies are perceived as inflationary: Charles Plosser, a member of the Fed's policymaking committee and the president of the Federal Reserve Bank of Philadelphia, has been a leading critic of the bond-buying program. Although it's intended to pump cash into the economy and keep interest rates low, Plosser argues that QE2 may backfire by stoking inflation.

Inflation has been so low recently that the Fed has been more concerned about deflation and has been trying to get at least some inflation back into the economy. But it's a question of balance and control because inflation acts as a "hidden tax" on the economy: Goods and services cost more, leaving households and businesses less money for consumption and investment.

And inflation isn't just bad for wage earners. It's also the mortal enemy of long-term bonds. As inflation rises, yields (and interest rates) must rise too, lest investors lose money in buying a bond. If a bond yields 3% (about what a 10-year Treasury bill pays now) and inflation is running at 6% a year, the bond holder will lose 3% of his capital every year.

Even worse, the market value of the bond would plummet. To understand this, imagine the bond yield and the bond's market value as two ends of a see-saw. If yields decline, existing bonds rise in value. If yields climb, the value of existing bonds falls.

For instance, if bond yields rise from 3% to 5% -- still a historically low rate -- that would mean that all existing bonds would be repriced so that they, too, yield 5%. A $100 bond that now pays 3% -- or $3 -- would be worth only $60 at 5%. That's a 40% cut for the bondholder -- a very painful loss of capital.

This type of loss in value already has been happening. Bond funds saw declines of 3% or more in December as yields rose. No wonder the bond market is skittish about potentially inflationary Fed policies.

2. Investors expect higher interest rates and yields: As Vishesh Kumar reported here earlier this month, big-name investors such as Warren Buffett are anticipating higher interest rates and yields.

Because of that expectation, savvy investors aren't waiting for inflation to kick in to demand higher returns on their capital: They're demanding higher yields now in order to compensate for future inflation. And as bond buyers demand higher yields, this investor anticipation of higher rates can actually drive those rates up.

3. Global competition will push rates higher: The Federal Reserve doesn't maintain exclusive control of bond yields. They're also set by the global market for bonds, which is constantly balancing the risks of inflation and default against the yields of government and private debt.

According to a lengthy report from the International Monetary Fund, nations around the world will soon need to issue new bonds to finance monumental sums of capital. This includes new bonds sold to pay off maturing bonds, as well as new bonds to finance current deficits.

The IMF expects the U.S. will need to finance roughly $4 trillion through new bonds this year, which amounts to 27.2% of the country's GDP, while Japan will need to raise some $2.5 trillion, or a staggering 59% of its GDP.

Add in heavy borrowing needs by other large economies, such as Italy, and the total demand for new bond-based governmental funding exceeds a whopping $10 trillion, a sum that threatens to exceed the supply of cash available to buy these bonds.

And that's just for 2011. With some governments, such as the U.S., running gigantic deficits every year, the need for trillions more in new financing will likely continue into 2012 and beyond.

The IMF warned that all the refinancing -- and the higher risk of default -- could erupt into a "full-blown sovereign debt crisis," which would surely drive rates higher for all borrowers, not just for at-risk borrowers like Greece and Ireland.

4. The U.S. is running unprecedented deficits: The U.S. is adding to the ballooning burden of global debt with record national deficits that have added a mind-boggling $5 trillion to the national debt since 2008. Why? The country's imbalance between tax revenues and spending is also unprecedented, with tax revenues of around $2.3 trillion and spending of about $3.8 trillion. It is borrowing $1.5 trillion -- roughly 40% of its expenditures every year -- to make up the gap.

Even if investors remain absolutely confident that the U.S. will never default on its rapidly rising debts, the supply of all the new bonds from other nations will likely exceed the overall demand for bonds. And that means interest rates will likely rise as governments and private bond issuers compete for investors' cash.

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Chip

Why do interest rates keep rising despite QE2? First, Keynes was wrong and "stimulus" doesn't work. Second, interest rates have been unnaturally low for a long time due to government interference with the market. Does that clear it up?

January 18 2011 at 9:42 PM Report abuse +1 rate up rate down Reply
cmptrgru34

When are my fellow Americans going to change their investment strategy? Single family homes are not the way to go. Nope if we want to stimulate the economy, then we need to use the bond money or loans to purchase and fix up hotels, apartment complexes and other types of commercial real estate. There seems to be plenty of that listed on www.loopnet.com.

January 18 2011 at 7:43 PM Report abuse -1 rate up rate down Reply
rp5599

WHEN IT COMES TO THIS ADMINISTRATION THERE IS MORE QUESTIONS THAN ANSWERS.....CHINA COMMING???? WE WILL KISS A-- FOR 4 DAYS AS THEY PREPARE TO TAKE OUR COUNTRY.....AMERICA WAKE UP!!!!!! OBAMA MUST GO!!!! PLEASE VOTE!!!

January 17 2011 at 2:45 PM Report abuse +2 rate up rate down Reply
tmbdab

When are Americans going to give up on trying to bring back manufacturing?WE CAN'T compete unless we are willing to work for 25 cents and hour...don't you get it? That difference in labor cost between us and Thailand, Vietnam, India, etc, can't be made up in shipping costs. The new jobs MUST be in technology and we must let the brains in that can't get in because of the HIRE AMERICANS first. I support that, but after the ones that are of the right intelligence level are hired, let anyone else in the the tech companies want or these companies will start having their headquarters in overseas markets. And the deficit? Stop worrying about it. ....we give them paper, they give us goods.......pretty good trade for us. We inflate out of part of it and profit our way out of the rest. It will happen. Also, we have been worrying about all this hyperinflation...it is always talked about in the future for the three years we have been printing. WHERE IS IT???WHERE IS IT???? That is why gold is dropping. Printing money isn't like spending money. Volitivity and speed of money's circulation has more to do with inflation than just printing it. Look, print trillions of dollars and put it all in a warehouse......do you then have inflation? NO...not until people start circulation all that money.. We are in a situation where the money isn't circulating. As circulation of the printed money speeds up, inflation will pick up and the Fed will issue notes to soak up some of that money to prevent hyperinflation.....For God's sake folks, go take some economic classes. We aren't headed for socialism or hyperinflation. Stop listening to the fear-mongering idiots.

January 14 2011 at 11:37 AM Report abuse -6 rate up rate down Reply
1 reply to tmbdab's comment
Robert & Lisa

Totally not true. We can compete if our government will stop overtaxing and spending too much.

January 14 2011 at 11:47 AM Report abuse +5 rate up rate down Reply
k4jlp

PEOPLE, THE REPUKES AND DEMONCRAPS ARE EXACTLY THE SAME, THEY SPEND MILLIONS TO GET ELECTED, WORK THE SWEETHEART DEALS WITH THE OIL, INSURANCE LOBBY THEN TAKE THE DEAL AT THE END FOR LIFETIME JOBS. NO LONGER ARE THEY REALLY REPRESENTING ME...TIME FOR A CHANGE ON THE WAY THINGS WORK. BANKS GET THE MONEY AT ZERO INTEREST AND CHARGE AS MUCH AS 30% ON SOME CREDIT CARDS...THE OIL INDUSTRY IS DRAINING THE REST OF IT WITH THE UN-CHECKED GREED IN PLAIN VIEW...THERE IS A PRICE FIXING INVESTIGATION STARTING ON CRUDE FUTURES SPECULATION...GOLDMAN SACHS WILL BE AT THE TOP OF THE GREED PILE...

January 14 2011 at 7:35 AM Report abuse +4 rate up rate down Reply
gmini10

Lower wage's = Lower price's

January 14 2011 at 6:47 AM Report abuse -1 rate up rate down Reply
1 reply to gmini10's comment
CGALLAGHER

LOWER WAGES= More Profit for CEOs

January 19 2011 at 8:34 AM Report abuse +2 rate up rate down Reply
bygbubba

Gold is down $20 this morning. I sure hope it keeps going down so I can buy what I sold. I sure made a mistake selling too soon.

January 14 2011 at 5:30 AM Report abuse rate up rate down Reply
Robert & Lisa

The Wall Street crooks that so many of you liberals assume are Republican are actually people like evil, ultra rich man George Soros who have spent millions backing corrupt Demoncrat politicians. They want a Socialist government because that will eliminate you middle class people making you part of the growing poor and give them all the wealth and power.

January 14 2011 at 4:16 AM Report abuse +11 rate up rate down Reply
1 reply to Robert & Lisa's comment
surfr45

Why yes, that is exactly what has been done in Socialist Mexico. They have "The richest man in the world", they are the largest producer of silver in the world, and they have lots of oil, yet the average Mexican lives in poverty, making less than six dollars a day. That is what our evil, ultra rich TV and Movie Stars want here. It gives them all of the power and wealth. And the poor duped Democrats will never figure out what hit them until it is too late. Brilliant.

January 14 2011 at 4:21 AM Report abuse +10 rate up rate down Reply
chicobombico

Smart real smart, lets make the Wall Street Crooks happy raise it to 30 percent that will get everyone back to work.

January 14 2011 at 12:58 AM Report abuse rate up rate down Reply
rghland

We have a million barrels of oil per day in anwar and the pipeline is only 20 miles from it.We have 100 year supply of natural gas. They are finding hugh amounts of oil in the gulf and with the horizontal drilling the are finding a lot of onshore oil. we could knock off about 4 million Barrels per day within 4 years. All this Oil & Gas is taxed along with good paying American jobs. What are we doing, burning our food! This won't solve all our problems but it could make a biG IMPACT

January 14 2011 at 12:55 AM Report abuse +4 rate up rate down Reply