Rising Treasury Note Yields Could Threaten Economic Recovery

Rising interest rates could quickly derail chances of an economic rebound in 2010 and would cancel out the efforts of government to stimulate the housing market. However, with an alarming report from Morgan Stanley that projects a 40% increase in the yield of benchmark 10-year notes, the economy could face a major obstacle in 2010. See the following from Expected Returns.

The artificially low interest rate environment manufactured by the government is about to come to an end, at least according to Morgan Stanley, which sees a 5.5% note in 2010. The implications of such a rise in interest rates are profound and will be felt at all levels of the economy. From Bloomberg:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

Investors are demanding higher returns on government debt, boosting rates this month by the most since January, on concern President Barack Obama’s attempt to revive economic growth with record spending will keep the deficit at $1 trillion. Rising borrowing costs risk jeopardizing a recovery from a plunge in the residential mortgage market that led to the worst global recession in six decades.

The Treasury will sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year, Morgan Stanley estimates. Caron says total dollar-denominated debt issuance will rise by $2.2 trillion in the next 12 months as corporate and municipal debt sales climb.

The primary concern in a rising yield environment will be its effect on housing prices. If tax credits and direct MBS purchases couldn't lift housing out of the abyss, imagine what mortgage rates at 50% above current levels will do to housing. The Option ARMageddon that is already set to drag housing down in 2010 will pick up even more steam as resets occur at much higher rates. Keeping this in mind, do you really think the Fed will raise interest rates in 2010 as so many people expect?

Debt Servicing Costs Set to Rise

“There’s no free lunch, and when you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said. “Foreign central banks are just not going to be able to finance these kinds of budget deficits for very long.”

Monetary officials in China, Japan and other countries helped Geithner lower U.S. borrowing costs by 15 percent in the government’s 2009 fiscal year. Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.

The decline in interest expense was the biggest decrease since before 1989 and came even as the nation’s debt increased by $1.38 trillion this year to $7.17 trillion in November, the data show.

Our debt burden is so great that even a slight increase in yields will cause serious strains to our budget. Interest obligations were relatively small in 2009 due to record low debt servicing costs. Interest rates were, of course, suppressed through the Fed's program of quantitative easing. Unfortunately, the party is about to come to an end because when about 40% of Treasury purchases are carried out directly by the Federal Reserve, you have a recipe for disaster. We can easily see interest payments on our debt rise 100-200% in 2010, which should put a lid on any economic recovery.

This post has been republished from Moses Kim's blog, Expected Returns.