Our Feet To The Fire

Nearly everyone that has paid the slightest bit of attention to the talk in the press or on the TV is aware of the fact that the Federal Reserve Bank has been bring the interest rate down on a key interest rate known as the fed funds rate. That interest rate now stands at 2.25%. This is a good thing, but interest rates in a global market place can cut both ways.

The fed funds rate is the overnight interest rate that banks charge each other for lending funds overnight. From this rate, the entire yield curve of U.S. Treasury rates can be constructed. Let me explain. The interest rate on the 2-year US Treasury Note is now 1.55%. Going out another 3 years is the 5-Year US Treasury Note with an interest rate of 2.39%. Taking the maturity of the US Treasury Note out another 5 years to 10 years takes the interest rate up to 3.36%. And, now the 30-year US Treasury Bond’s interest rate is 4.22%. If you plot these points on a piece of graph paper with interest rates running up the vertical axis and the years to maturity running left to right across the lateral axis, you have what is known as a positive sloping yield curve. When you consider where U.S. interest rates have been over the last 30 years, interest rates today are in the bottom of the historical range.

This gives the Fed some room to work, while at the same time the Fed must consider what lower interest rates and a falling US dollar means to the movement of money into and out of the US currency, and thus, being invested or not invested into US Treasury Notes and Bonds.

If US Treasury interest rates fall to a level where the decline in the value of the dollar as measured against other major world currencies, leaves the foreign investor with a negative rate of return, after investing in US Treasuries for a given period of time, then foreign buyers of US Treasuries will stop buying US Treasuries and look for other government’s debt to invest their cash. Keep in mind that foreign investors hold US dollars in their currency portfolio by choice, not by necessity.

The Fed and the US Treasury knows this only too well. U.S. Interest rates can only be reduced so far before foreign buyers of U.S. Treasuries decide to buy notes and bonds not denominated in US Dollars. Add to this the reality of the billions of dollars of oil and foreign goods that are being imported everyday into the United States, and the economic equation, in my mind, takes on the appearance of a perfect circle. As long as the US dollar is attractive enough to foreign buyers to hold US dollars in their portfolios and in turn invest in US dollar denominated securities, things will be fine. However, if inflation should accelerate in our domestic economy and foreign holders of US denominated securities conclude that given the low rate of interest they are receiving, and the decline in the value of the US dollar, that the total rate of return is a negative number or that it will be very shortly a negative number, then foreign investors will start selling US Treasuries on the market in large quantities and push our domestic interest rates up. And, the last thing our slowing domestic economy needs now is rising interest rates.

This is what I mean when I say low interest rates can cut both ways. Inflation destroys purchasing power. When the dollar falls in value against other major world currencies and foreign investors can calculate that the return on their fixed income investment is now a negative return after it is converted into another major world currency, the rationale for holding US dollar denominated securities has no point.

In a global market place the policies of the United States, both monetary and fiscal, hold our collective feet to the fire. We can not do as we please because there are consequences for our actions or our inaction. Stay tuned.