Harvard’s Feldstein: Rising Rates Will Cause Financial Market Meltdown

Tuesday, 02 Apr 2013 08:01 AM

By Michael Kling

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Rising interest rates may cause a financial market breakdown, warns Martin Feldstein, a Harvard economics professor and former chairman of Ronald Reagan’s Council of Economic Advisors.

“Even if the major advanced economies’ current monetary strategies do not lead to rising inflation, we may look back on these years as a time when official policy led to individual losses and overall financial instability,” Feldstein writes in an article for Project Syndicate.

Super-low Treasury rates show mispricing of financial assets, he says. Because inflation is about 2 percent, the 10-year Treasury has a negative real interest rate. Historically, the real interest rate has been over 2 percent, but fiscal deficits and government debt was smaller in the past. Government debt has ballooned and continues to grow.

Editor's Note: The Final Turning Predicted for America. See Proof.

Under those circumstances, Treasury rates should be much higher, but remain low because of the Federal Reserve is buying $85 billion of securities through its quantitative easing program.

“Since that exceeds the size of the government deficit,” Feldstein writes, “it implies that private markets do not need to buy any of the newly issued government debt.”

The Congressional Budget Office (CBO) predicts 10-year Treasury rates will rise above 5 percent by 2019 and stay above that level for the next five years, he notes. But the CBO assumes inflation of 2.2 percent.

“If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher.”

Investors holding 10-Treasurys would probably see falling bond prices wipe out any additional yield, even if rates remain unchanged for the next five years.

Suppose you roll over 10-year bonds for the next five years, earning an extra 2 percent more than short-term investments, and rates remain unchanged for five years then rise from 2 percent to 5 percent.

“During those five years, the investor earns an additional 2 percent each year, for a cumulative gain of 10 percent,” he says. “But when the interest rate on a 10-year bond rises to 5 percent, the bond’s price falls from $100 to $69. The investor loses $31 on the price of the bond, or three times more than he had gained in higher interest payments.”

Fear of rising rates has become widespread, and investors are seeking more floating-rate and short-term bonds in an attempt to protect themselves against rising rates. In response, banks are issuing more of those bonds.

Reuters reported strong demand for floating rate tranches issued by Bank of America and Capital One.

“We have seen a material increase in new issuance as well as spread compression in floaters in the last few months as the buyer base has expanded beyond the traditional securities lending community,” Brendan Hanley at Bank of America Merrill Lynch told Reuters. “Many of the new investors are looking for protection from rising rates.”

Editor's Note: The Final Turning Predicted for America. See Proof.

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