The Coming Rise in U.S. Interest Rates Not That Far Off

US Interest RatesAt the beginning of this year, some analysts were predicting that U.S. interest rates would rise in the later part of 2010, early 2011. Those forecasts have simply been put on hold because the U.S. economy is recovering at a much lower growth rate than previously predicted.

I read one report this weekend from a well-known economist who believes that the Fed will not be able to raise interest rates until 2012. I see that as too far out. By 2012, U.S. government debt will be about $15.0 trillion. I doubt that investors will keep buying those T-bills at today’s current reduced interest rates as U.S. debt balloons.

My personal opinion is that we should not be so cocky in expecting interest rates to be low for the next two years.

Look at these five important economic realities:

Interest rates are low in the Fed’s effort to get the economy going, accelerate job growth and help the anemic housing market. Low interest is also a bonus for a government saddled with record debt, like the U.S. is today.

But interest rates being low have a negative impact on the economy as well. A Federal Funds Rate of zero is artificial. The low-interest-rate, easy-money policy we have today tempers inflation. Because of economic uncertainty, especially following the Greek crisis of this spring, investors have been flocking to the U.S. dollar for safety. This will not last forever.

Eventually, as more debt is piled on by the government, the U.S. dollar will come under immense pressure against other world currencies. A lower valued U.S. dollar is ideal for us, but a dollar falling too rapidly could push foreigners away from the greenback, and the only way to stop that is via higher interest rates.

As the economy improves, large U.S. corporations, which are not borrowing right now, will re-enter the market with corporate debt. This will put U.S. Treasuries in competition with quality U.S. corporate bonds, pushing up interest rates, as more debt competes for the same takers.

Finally, why isn’t the U.S. stock market higher today than it is? The dividend yield on stocks is close to three percent and the yield on five-year Treasuries is less than half of that.

The yield on the popular 10-year U.S. Treasury is close to the dividend yield on stocks today. Could the stock market and the bond market both be wrong at the same time (stocks predicting higher interest rates ahead, long-term bond market predicting slower economic growth for years to come)?

Investors shouldn’t take today’s low-interest-rate environment for granted. Similarly, they should not expect these low rates to last for years. Interest rates will surprise on the upside quicker than the majority of today’s analyst and economists expect.

Yes, Japan needed to keep its interest rates low (near zero) for more than a decade, and there have been many comparisons of Japan’s “lost decade” to today’s fragile U.S. economy. But the yen was not the reserve currency of 70% of all central banks. And that makes a world of a difference.

Michael’s Personal Notes:

According to RealtyTrac Inc., lenders foreclosed on 92,858 U.S. homes in July, up nine percent from June and up six percent from July 2009. RealtyTrac expects over one million homes in the U.S. to be lost to foreclosure this year.

The above is obviously bad news. But, as I have been writing in these pages, the fall in U.S. home prices has tapered off. Prices have stopped falling, but obviously prices are not rising either, given the glut of foreclosed properties on the market.

The number of U.S. homeowners receiving their first default notice fell sharply in July, down 28% from July 2009. This is good news.

Good deals in the U.S. real estate market abound. But if you are planning to take the dive, for investment or vacation purposes, you will have to hold that property for years before you start to see any price appreciation.

Where the Market Stands:

The Dow Jones Industrial Average starts this week down two percent for 2010.

With the Dow Jones price/earnings multiple at 14 and the dividend yield at 2.7%, when compared to three-month U.S. Treasuries yielding 0.15% or five-year U.S. Treasuries yielding only 1.44%, I do not see stocks as expensive at this time.

I continue to believe that the bear market rally that started in March of 2009 is alive and well.

What He Said:

“When I look around today, I see falling stock prices…I see falling house prices…and prices falling for retail goods stores declining. The media has it all wrong blaming (worrying about) inflation. In my opinion, the single biggest threat to the U.S. economy and to the Fed in 2008 is deflation. You can bet the Fed will expand the money supply and drop interest rates aggressively as deflation starts to rear its ugly head.” Michael Lombardi in PROFIT CONFIDENTIAL, December 17, 2007. Michael was one of the first to warn of deflation. By late 2008, world economies were embedded in their worst bout of deflation since the Great Depression.