In Today's Calmer Markets, Interest Rates Both Rise and Fall

Last Updated Jul 27, 2009 6:10 PM EDT

Interest rates on U.S. Treasury bonds are rising this week, as the government conducts king-sized auctions across a range of maturities, totaling a record $115 billion. Investors are still eager to buy Treasuries, but with a recovery (and inflation) in the works T-bonds are no longer the only game in town, so buyers are insisting on higher yields as compensation. Short-term treasury rates are still very low, however, and as the threats to bank survival recede in the rear-view mirror, their funding costs are once again based on economics, rather than fear.

The Treasury has begun a record auction of bonds, with $115 billion worth of securities coming in maturities of two, five, and seven years, as well as 20-year inflation protected bonds (TIPS).

Relative to their own long-term history, Treasury yields are low, but they are climbing: the 10-year bond yield rose Monday to about 3.7 percent, up from below 2.5 percent at the end of last year. The recent rise in the stock market suggests that investors see a recovery out there somewhere, and are willing to invest again in more risky assets. That means the safe haven aspect of U.S. Treasuries is less of a focus, and bonds will have to earn their keep by paying higher yields.

Bloomberg contends that bonds are appealing for their high "real yield," or the cash yield less inflation:

Treasuries are the cheapest relative to inflation since 1994 after consumer prices fell 1.4 percent in June from a year earlier. The real yield, or the difference between rates on government securities and the real cost of living in the economy, is 5.10 percent for 10-year notes, compared with an average of 2.74 percent over the past 20 years.
That interpretation may be strictly correct based on recent inflation, which has indeed turned negative. But core inflation, that is, the CPI excluding energy and food, is still running at about two percent, and it won't be long before the drop from $147 oil works its way out of the math, and inflation is positive again. Thus the ten-year bond may not look like such a bargain 12 months hence.

Short-term Treasuries are selling at very low yields, however -- less than one percent for maturities up to one year. Rate in the short-term credit markets have been falling too, as measured by the London Interbank Offered Rate, or Libor. (As the name suggests, Libor is what banks charge in lending to other banks, and in fact there are many Libor rates, varying with the term of the deposit and the currencies involved.)

On Monday three-month U.S. dollar Libor settled to about 0.50 percent, down from a recent high of about four percent at the time of the Lehman Brothers bankruptcy. That's a very low level, but nonetheless is the most normal reading we've had for Libor in a long time, in terms of where it stands in relation to other short rates.

Libor typically tracks U.S. Treasury bills of similar term, at a spread of about 0.50 percent, but it exploded in the past year, reflecting banks' growing doubts about the creditworthiness of their competitors.

Bloomberg provides a nifty interactive chart of the Treasury-Libor spread (known as TED, for Treasury-Eurodollar), illustrating the jitters in Libor last year in the days of Lehman, when the TED spread hit 3.6 percent even as T-bill rates were falling.

Variable-rate mortgages are often based on Libor, so if you're a floating rate borrower, enjoy it. Unfortunately, banks seldom pass on savings in their funding costs on other consumer products, such as credit cards. But a healthier banking sector helps the financial stocks: from April through late July, the S&P 500 is up 21 percent, while the financials have climbed about twice as much.

Investment disclosure: The writer owns shares of a financial ETF, and an inverse Treasury bond ETF.