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 questions.

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 (or earned). 

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 interest rates. 

(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. 


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