Tuesday, January 3, 2012

Double Digit Interest Rates Are Back?

Treasury bonds had a really good year in 2011 with the 10-year bond yielding under 2% at the end of the year for the first time since at least 1977 and the 30-year bond under 3%. This is good news for bonds at first glance. But is it?

An improving economy and a Federal Reserve ending Operation Twist, where short-term Treasury bills are sold to buy long-term Treasury bonds, comes to an end, leaving future gains for bonds in doubt. Unless the economy declines, interest rates will head higher in 2012. There are few reasons remaining for the Federal Reserve to continue pushing rates lower.

How high rates go and when is anybodies guess. History has an interesting reference though. When we consider the low 10-year Treasury bond yield at the end of 1977, one concern comes to mind. A few years later interest rates pushed toward double digits and later went well over 10%.

If history repeats, which is no certainty, interest rates could head a lot higher. There are notable differences, however. Inflation is less an issue today than in 1977. Demographics are significantly different. Tax rates are lower and greater global trade should keep inflation lower. Energy prices are less an issue today because of more efficient use of these resources.

The differences aside, one overwhelming fact remains: Interest rates can go from very low to very high very quickly. The good 'ol days of low interest rates are coming to an end. It might take another generation to see these rates again.

Anybody for a 14% 30-year Treasury bond?

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