September 17, 2003
Despite a recent rally in the bond market, the gap in
interest rates between overnight money and ten year bonds is among the largest
in history. That raises two
First, will this gap widen or narrow in the next year or
so? Second, should homebuyers and
corporate financial officers change their borrowing habits to exploit the
existence of this interest rate gap?
Before projecting what will happen to this interest rate
gap, I should explain why it exists.
As I have mentioned in some previous columns, lenders are
concerned about three factors when they decide to lend what they have produced
First, they want to get the same purchasing power back that
they are giving to the borrower. No
one knows what future inflation will be, but the borrower has some expectations
of what might happen. The borrower
must be willing to pay interest sufficient to meet the inflationary expectations
of the lender.
Second, the lender normally needs to be bribed to forego
using current earnings for current needs. In
rare instances, lenders might be so concerned about future earning power that
they will not need to be bribed to save. This currently is happening in Japanese households. However,
unusual fears of future conditions need to persist for such conditions to occur.
Indeed, if borrowers are increasing their desire for
current resources, the bribe might be very large.
In the mid 1980s, when governments were borrowing 6 percent of GDP while
inventories were rising, capital spending was booming, and home buying was
brisk, interest rates were unusually high relative to inflation.
Normally, 1.5 to 2.5 percentage points is needed for this purpose.
Third, lenders might need to find buyers for their holdings
before the debt matures. There is a
risk that prevailing interest rates at that time may be higher or lower than
when the lender structured the term of the loan. While the lender might receive a gain, a loss also may be
suffered. To cover this risk of
interest rate fluctuations, lenders want some additional return as they extend
the length of their notes.
Over the latest thirty year period, ten year government
bonds averaged about 1.1 percentage point higher yields than overnight money
(the federal funds rate). Let's
assume that is the normal premium needed to pay for the risk of fluctuating
(If lenders are concerned with the credit quality of the
borrower, there will be a fourth premium for credit quality risk, but that is a
much more complicated factor than the other three).
Short term interest rates should be determined by the first
two factors, while the spread between short and long term rates would be
dictated by the third factor over time.
The Federal Reserve has substantial say over short term
rates. If the Fed believes the
economy is too sluggish, it will push short term rates below equilibrium to
stimulate the economy. For example,
federal funds rates currently are 1 percent.
Using the first two factors, equilibrium federal funds rates should be at
least 3.5 percent (1.5 percent for expected inflation and 2 percent to forego
current use of earnings).
While the short term subsidy has some impact upon longer
term rates, the 10 year bond more closely reflects equilibrium conditions.
Because the Fed subsidy is so large, the gap between short term and long
term rates is unusually wide.
So, the answer to the first question at the start of this
column depends upon what the Federal Reserve will do to subsidies.
Most economists believe that no movement toward higher short term rates
will develop until several months of employment gains develop.
My own forecast is that such conditions will not occur until near the end
of 2004. As rates are unlikely to
rise rapidly even after they start increasing, below equilibrium short term
rates are likely through 2005.
Should you lock in longer term money at today's rates or
borrow at the short end until those rates begin rising sharply?
Clearly, planning and sleep are more easily met when rates
are fixed. If you will not have the
cash flow to retire the corporate debt until soon before it matures, then you
should use the fixed rates.
However, if the cash flow is sufficient to pay off the
bonds well before they mature, use short term financing and save the interest
charges in the first couple years of borrowing.
Aside from using interest only loans to become qualified
for the home of your dreams, you might want to use such financing if you pay
down the principle with the interest saved relative to the fixed rate mortgage..
When short term rates inevitably rise and your interest charges increase,
the size of your note will have decreased sufficiently to allow refinancing
without spending more than the original fixed note would have required.
Use the subsidized short term rates, if you do not need to borrow very long.