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Interest rates are going up. Although the Fed will attempt to hold the Federal Funds Rate at 1.0% and the discount rate at 2.0%, the demand for money is increasing. Nearly every level of American government is incurring deficits. The central (federal) government deficit was US$374.44 billion in the fiscal year that ended 30 September 2003, but the national debt rose US$576.27 billion in that year because many expenditures were postponed to the current fiscal year and the deficit is reported with trust fund surpluses. State and local governments are experiencing severe shortfalls. In the coming year public officials will be begging for credits from investors/lenders.
The momentum behind increases in interest rates is being limited by government authorities, who recognize that any increase in the cost of money will add to the budget deficit. In FY2003 the federal government paid US$318.15 billion in interest to holders of the national debt, compared to US$332.54 billion the previous year because of low yields on debt securities. The 10-year bond was 3.98% on 14 January 2004, compared to a low point of 3.33% in July 2003. This trend will continue.
Three factors are limiting investor willingness to buy U.S. federal and local government debt securities:
- American observers have generally concluded that interest rates have reached the low point. A risk premium is being sought by buyers in the market for debt securities because of a potential loss of capital. (See below for an example of how this occurs.)
- Foreign investors, having made enormous capital gains in the American bond market during recent years, are selling to realize their profits. Most expect a rising demand for debt securities and a decrease in investor willingness to commit funds. This will add upward pressure on interest rates.
- The capital gains by foreign investors have been diminished by a decline in the value of the US$. Perceptions of further losses in the US$’s value against major currencies, reinforced by huge budget and current accounts deficits, are causing reluctance to invest. The large net outflow of US$s to foreign suppliers of goods and services and foreign transfers of income is no longer being matched by inflows into equity and debt securities. The euro will be a safer place for investment and savings in 2004.
Example:
When interest rates go up, the value of debt securities goes down. For example, a US$1000 bond is issued with a coupon rate of 4.0%. This bond yields US$40 annually. If interest rates fall to 2.0%, the bond’s market value theoretically rises to US$2000 because 2.0% of US$2000 is US$40. Actually, the market also reacts to such other factors as time of maturity, but the direction of bond prices is sharply upward under these conditions. If interest rates rise to 5.0%, the bond’s market value theoretically declines to US$800 because 5.0% of US$800 is US$40.
Risk in lending to American consumers is increasing. In 2003 inflation has been relatively stable, consumer prices rising 2.2% in the year through September. Economic expansion was 3.6% during October 2002-September 2003, but minimal job formation took place. The unemployment rate decreased to 5.7% in December because of seasonal temporary employment. Workers are generally insecure about their future, and lenders are becoming cautious about extending consumer credit because of excessive borrowing and enormous credit card obligations relative to capacity to pay. The past standard of having two workers in a household is changing to one worker in many cases. The rising risk exposure requires higher real interest rates.
The prime rate is currently 4.0%. Sixty-month new car loans averaged 5.52% in mid-December, nearly unchanged in six months. It is predicted that the prime rate will reach 5.25% by mid-2004 and that the spread between the prime and other retail rates will increase. Therefore, the rate for sixty-month new car loans will be about 7.0% in June 2004, excluding sales incentives offered by manufacturers.
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