Why Rates Won’t Fall By Much This Year

Last week’s U.S. government auction of two-year notes drew the weakest demand in nine months. Demand for the $22 billion in U.S. treasuries trying to be sold was much weaker than expected.

Bloomberg News quoted Robert Auwaerter of Vanguard as saying. “the market is extremely concerned about the amount of supply coming out.” The supply is there because the money is needed to fund an increasingly large U.S. deficit.

The U.S. is becoming increasingly dependent on foreigners to buy its debt securities. While foreigners only owned about one-third of all U.S. treasury securities as recently as five years ago, today foreigners own about half of all outstanding U.S. treasury notes.

One really has to wonder if the Federal Reserve Board’s actions in lifting rates 13 times in a row (soon to be 14 times) since mid-2004 was more than just an effort to cool the heated housing market. After all, with government debt spiraling, we are becoming more and more dependent on foreigners to finance our debt.

In the past, with foreigners flush with the U.S. dollars they received for their oil and other American-wanted products, American short-term securities were a good place to park U.S. cash. But, the economic environment may be different now. Foreigners could be looking for a higher return on their investments now because they are concerned about too many dollars in circulation.

Last week, President Bush signed legislation raising the maximum government debt by another $800 billion. When will the spending stop? When so many U.S. dollars are printed that no foreign country wants them?

As it becomes further apparent that higher interest may be needed to attract foreigners to our debt, higher rates might have to remain. You may want to take those predictions of lower rates ahead, as many analysts are predicting, with a grain of salt. Sure, lower rates could spur the softening U.S. economy, but if they go too low we’ll have a problem funding our deficit. It’s a classic Catch-22 situation. And, a U.S. dollar declining too quickly against other world currencies will likely push American rates higher.