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Long-Term Interest Rates Buck Conventional Wisdom

June 10, 2005|Tom Petruno | Times Staff Writer

The surest bet on Wall Street a year ago was that long-term interest rates would rise, boosting the cost of home mortgages and in general making credit tougher to get.

That forecast seemed to make perfect sense because the Federal Reserve was raising its bellwether short-term rate for the first time since 2000. Long-term rates usually move in tandem.

But that sure bet has been a big bust: To the shock of most investment pros as well as the Fed -- and to the relief of home buyers -- long-term rates have tumbled, even as the Fed has raised its key rate eight times over the last year, from 1% to 3%.

While the housing market celebrates the good news of 30-year mortgage rates under 5.6%, down from 6.3% a year ago, a lot of financial professionals have egg on their faces.

"Basically, 100% of economists have gotten the direction of long-term interest rates wrong," said Steven Permut, a money manager at American Century Investments in Mountain View, Calif.

Now, a new school of thought is developing among market analysts. Some believe long-term rates could hold at current levels for years, or even fall further to low single digits. In a world awash in savings, investors' urgency to lock in returns on fixed-rate, long-term IOUs like bonds will help keep a lid on rates in general, they say.

Bill Gross, chief investment officer at Newport Beach-based Pacific Investment Management Co. and one of the world's top authorities on interest rates, says it's conceivable that the rate on the 10-year U.S. Treasury note, a benchmark for mortgages and other long-term interest rates, could drop to 3% in the next three to five years. Currently it's just under 4%.

If he's right, that could mean that far lower mortgage rates lie ahead -- which could provide a bailout for people who have purchased homes with huge, interest-only loans and are hoping to eventually refinance with more favorable terms.

Some experts, however, say Wall Street is taking a familiar tack: Tired of being beaten by the market for so long, more analysts now are joining it.

"We're probably reaching a point where everyone just throws in the towel" on the idea of higher long-term interest rates, said Michael Darda, an economist at investment firm MKM Partners in Greenwich, Conn.

But that kind of capitulation often signals the end of the very trend that investors are jumping aboard, he said.

Recent history provides a glaring example, Darda said. In the first few months of 2000, after two years of spectacular gains in technology stocks, many investors who had avoided the shares in 1998 and 1999 were scrambling to get in at any price. That proved to be the zenith for the tech mania.

For its part, the Federal Reserve says it can't explain why interest rates have diverged. In testimony before Congress' Joint Economic Committee on Thursday, Fed Chairman Alan Greenspan said "something unusual is clearly at play here" -- repeating a view he has had since February, when he called the decline in long-term rates a "conundrum."

The Fed, as the nation's central bank, controls short-term interest rates by changing the so-called federal funds rate, or what commercial banks charge each other for overnight loans.

Historically, the Fed has raised that rate when it wanted to slow the economy, usually because inflation pressures were building.

And when the Fed is lifting its key rate, long-term rates typically rise as well. But the Fed doesn't directly control long-term rates. They are set in the marketplace -- for example, by the level of interest investors demand on government bonds.

The annualized yield, or interest rate, on the 10-year Treasury note was as high as 4.87% a year ago, just before the Fed began raising its short-term rate from a four-decade low of 1% to the current 3%.

On Thursday, the yield on the Treasury note was nearly a full percentage point lower, at 3.95%.

What's more, the downtrend in long-term rates has been a global phenomenon. Government bond yields have fallen to generational lows this spring in major European economies such as Germany and minor ones such as Lithuania and Estonia.

In Japan, long the home of the world's lowest interest rates, the yield on the government's 10-year bond is at 1.23%, down from 1.78% a year ago.

It isn't just government bond yields that have plummeted. High-risk companies that borrow via so-called junk bonds also are paying less today for money than a year ago.

Stephen Roach, an economist at brokerage Morgan Stanley in New York, had been expecting U.S. long-term rates to rise this year. But last month he changed his forecast. "I now suspect bond yields will stay low for the foreseeable future," he said.

He cites, in part, the continuing hunger many investors -- and speculators -- have shown worldwide for bonds. As more people step up to buy, the effect is to allow governments and other bond issuers to pay less on their IOUs. That drives other long-term rates lower as well.

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