What Are Interest Rates Telling Us? Part III

(MoneyWatch)  Link to Part I
Link to Part II
U.S. interest rates are exceedingly low these days, as we have seen in the last couple of posts. They are low in spite of the Treasury's selling enormous amounts of bonds to finance our budget deficits, which in the view of many observers make higher inflation and higher interest rates inescapable. Other countries took the same steps during the credit crisis, and the markets are starting to show signs of worry that governments, even of prosperous countries, won't be able to repay their debts. Will the concern start to drive up U.S. interest rates?

On Thursday, while folks in the U.S. were eating turkey and watching football, the world's financial markets went into a panic after the emirate of Dubai asked for a standstill (in other words, went into default) on payments on borrowing by Dubai World, the government-owned company that manages those elaborate real estate projects in the Middle East. The U.S. markets weren't open, but trading in S&P 500 futures suggested a 2.2 percent drop in the market.

There is a market for insurance against the default of sovereign nations on their bonds - those useful Credit Default Swaps (CDS). Prices of that coverage have been rising in recent months, as the market's focus on the banking crisis wanes, and investors get a better view of what fixing the whole thing will cost us in the future. The volume of trading in such sovereign credit default swaps has doubled in the past year, and the cost has risen as well, according to the Financial Times.

Curiously, the increased trading has centered on developed countries' credit - the U.S., U.K., Japan and Italy - while the demand for protection is flat or down for Russia, Brazil and Indonesia. But it's in the developed world that the budget deficits are rising the fastest. From the FT:

Nigel Rendell, senior emerging markets strategist at RBC Capital Markets, said: "It is not surprising that investors are increasingly worried about debt in the industrialized world. Debt to GDP of more than 100 per cent is difficult to sustain."

On Thursday I called Gavan Nolan, who is a vice president of credit research at Markit, a London-based company that tracks the credit default swap market. In an index of 15 Western European countries, the cost of insurance has widened a lot in the past few weeks - 0.50 percent two weeks ago, up to 0.65 percent today. (Here's how it works: on the principal amount of the bonds you want to protect, you pay a bank that percentage each year, and if the bonds default, the bank pays you the full principal.)

Italy, Ireland and Greece are the worst cases among developed countries, but the cost of insuring U.S. bonds is up 50 percent in two months:


The market for U.S. coverage is small, just $10 billion, and Gavan Nolan said it doesn't trade much, so a big jump is to be expected.

But there is a message here about our federal budget situation. The federal deficit for the fiscal year ended September 30, $1.4 trillion, represents about 10 percent of GDP. We're hearing cautions from President Obama, again from the FT:

It is important though to recognize if we keep adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy...

Budget director Peter Orszag also says the country needs to get in better shape, and puts some numbers to it:

In the medium term out in 2015, 2016, 2017, we need to get to something around 3 percent of the economy so that debt is no longer rising as a share of the economy... Frankly I feel like my credibility is on the line in the document that we put out in early February [which projected budget deficits of about four percent for those years].

At Morgan Stanley, global fixed income economist Manoj Pradhan is willing to forecast where rates are headed. He expects that yields on 10-year U.S. Treasury bonds will rise to 5.5 percent by the end of 2010, an increase of 2.2 percent:

...[I]nvestors seem to be receiving no compensation for the macroeconomic risks that have surely made an indelible impression over the past two years, or for the fiscal risks that abound.