Look out for inflation driving rates up in 2010
December 26, 2009 by admin
The new year is right around the corner and with it brings renewed expectations of economic improvement and a greater possibility for inflation to be a key factor in the economy. Traditionally in a healthy economy, the rate of GDP is relatively contained and inflationary pressure is balanced through the Fed raising and lowering the rate on the Fed Funds and Fed Discount rate to keep inflation in check. The past twenty four months have been anything but normal as the Federal Reserve reacted aggressively to drop the Fed Funds rate down to zero attempting to stabilize the financial market and limit the economic recession. The zero percent Fed Funds rate has been a critical element that has helped stabilize lending. Banks have had the luxury of borrowing money from the Fed and lending it to the public with great margins, helping to improve their profit margins and provide some critical sources of revenue.
The month of December has been great for the stock market which again surpassed its high point for the S&P500 as investors are increasingly shifting into equity positions. The stock market has had minimal impact on the bond market for the greater part of the year, as long term yields have been near historic lows for most of the year, benefitting home owners and home buyers with great interest rates for home mortgages the entire year. This trend is starting to see a larger shift to traditional supply/demand equity and bond market swings. The improvement in the equity markets and the economy has left many investors of the opinion that inflation is going to become an issue into 2010. The threat of inflation in the market has one resounding effect, it pushes interest rates to move higher. This evidence of inflationary pressure in the market has been a key factor in driving the yield on the ten year treasury bond from 3.3% in late November, up to nearly 3.75% to end the month of December. Many experts are now predicting that the ten year treasury will likely surpass 4% in early January and could easily reach 5% in late 2010. The higher the ten year yield rises, the larger the spread between long term and short term rates will become until the FOMC addresses this area in the market. The short term potential for a large discrepancy between long and short term interest rates is certainly likely as investors are more likely to bet on an economic recovery, forcing long term yields, versus the FOMC which is likely to cautiously address the increase of short term rates as a measure to be certain the economy is firing on all cylinders. The likelihood of an increase in short term rates in the first quarter is fairly uncertain with most experts predicting the FOMC to raise interest rates in the second to third quarter of next year.
Inflation will be a hotly discussed topic over the upcoming months. Home buyers and owners should consider locking into mortgage rates quickly as there is little reason to believe that rates are going to move lower into 2010. The balance of short term lending should be safe as the prime rate has been unaffected by the recent increase in Treasuries. A key weapon to combat higher inflation is with higher interest rates, a scenario that could become a reality in the near future.