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With an improving economy and low unemployment, the country is now experiencing something it has not seen in a long time, rising interest rates. 10-year Treasuries have risen to five-year highs. The Federal Reserve Bank has also steadily increased the federal funds rate.
Due to these factors, interest rates are poised to move even higher. While higher rates signal a healthy economy, they also pose a concern as the Fed's need for higher rates conflicts with the government's need to service its debt at the lowest cost possible.
Interest Rates Have Begun Rising
The length of time for which the Fed kept interest very low remains almost without precedent. They took this route in hopes that it would stimulate the economy. Now, the Fed has gradually increased rates. As a result, we have now seen the likely end of the bull market in bonds that ran for more than three and a half decades.
One sign is the rise of Treasury yields, which serve as a basis for consumer loan rates. The benchmark 10-year Treasury had fallen as low as 1.32% in July 2016. In April, it rose above 3% for the first time since late 2013. As a result, the cost of borrowing has risen as rates rise above record lows. Goldman Sachs believes the 10-year Treasury will reach 3.6% by the end of 2019.
Higher Rates Will Become a Double-Edged Sword
To be sure, rising rates also signal a healthy economy. With unemployment falling to 16-year lows, consumers show a willingness to spend. Higher interest rates also benefit savers since banks such as Bank of America Corp (NYSE: BAC ), JPMorgan Chase & Co. (NYSE: JPM ) and Citigroup Inc (NYSE: C ) will have to pay higher interest rates to depositors.
However, due to the recent tax cuts, the deficit has risen despite the improving economy. Goldman correctly points out that this serves as an unusual and dangerous phenomenon in an improving economy. Now that the national debt has risen to the $21 trillion level, the cost of servicing that debt will grow larger with higher interest rates. This poses a threat to the U.S. economy as rising interest payments will likely lead to even larger deficits.
Fed Will Further Increase Rates
This all comes at a time when the Fed has little choice but to keep increasing rates. Most believe the Fed will hike interest rates four times this year, including the hike that occurred in March. Today, the federal funds rate stands at 1.7%.
Assuming the usual pattern of 25 basis moves continues, four hikes for 2018 would place the rate at 2.25-2.5% by the end of the year. While low by historical standards, it still stands as the highest rate in ten years.
Also, as Goldman points out, the Fed has begun the process of unwinding the balance sheet. The balance sheet increased from $900 billion in 2008 to $4.5 trillion by 2014. The Fed used this money to buy Treasuries which it now wants to sell. Due to the glut of government debt on the market, interest rates will likely have to rise further to attract buyers. Between the growing need for debt and the growing cost of servicing debt, a vicious cycle of increasing debt and interest rates could come to pass.
The Bottom Line on Interest Rates
Due to an improving economy, the Fed's need for higher rates and the U.S. government's need for low borrowing costs now conflict.
Goldman correctly points out that higher government debt costs could create a vicious cycle. The national debt has reached $21 trillion and continues to rise. Meanwhile, treasury yields now exceed 3%. As a result, the government's cost to borrow continues to increase, and debt service will likely claim a larger share of the federal budget.
If Goldman is correct, the government must act soon on the deficit. If they ignore this advice, the debt that was supposed to stimulate the economy could instead sew the seeds of the economy's destruction.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks.
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