Many Reasons for Rates to Rise

There are a number of scenarios and events that could cause rates to rise in the next several years. Increasing economic growth in the United States would mean that the Federal Reserve no longer needs to keep market interest rates artificially low. Central banks around the world have been buying debt to spur economic activity, with mixed result at best. When there is no longer a need to purchase more debt, the massive, coordinated demand for that debt will fall. And when that happens…uh-oh.

Growth of Central Bank Balance Sheets

Growth of Central Bank Balance Sheets

No other individual entity can match the purchasing power of a central bank. Under the basic laws of supply and demand, governments will have to make their debt more attractive in order to sell it after the massive demand from central banks dries up. The most likely scenario is that interest rates on government debt will rise until rates reach a point at which the free market allows the true intersection of the supply of bonds and demand for them to meet. At what rate level does that occur? Since the bond market has been off-kilter for so many years now, it is anyone’s guess.

Increased inflation caused by the Federal Reserve’s Quantitative Easing (QE) program could force the Fed to take money out of the financial system. The primary mechanism to do this is to increase interest rates so it is more attractive to lend money to the government.

Outside of economic reasons, remember that rates have been steadily falling since the 1980s. A simple “reversion to the mean” in which rates rise toward their long-term average (the average 10 year U.S. Treasury rate since 1926 according to data sourced from the St. Louis Federal Reserve’s website) would mean that rates would rise to about 5%. That’s almost a 2% increase from where we are right now. We suspect that would be more than enough to spur a dramatic change in investors’ attitudes toward bond investing, and to increase interest in viable alternative strategies for retirement income.

© Sungarden Investment Research

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