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In his Testimony earlier this week Alan Greenspan pondered why long-term U.S. interest rates have remained low even as the Fed raised the level of the target federal funds rate by 150 basis points. First, Mr. Greenspan suggested that long-term interest may be low because participants have ‘marked down’ their economic expectations, ‘perhaps because of the rise in oil prices’. Second, Greenspan suggested that interest rates are low because of the ‘eagerness of lenders, including foreign investors, to provide financing’ for ‘longer-term Treasury securities’. Third, Greenspan remarked that U.S. rates are low ‘because yields and risk spreads have narrowed globally’ and/or because ‘people experiencing long periods of relative stability are prone to excess.’ Incidentally, not many media outlets picked up on the word ‘excess’ – which was made in reference to the possibility that investor’s are chasing yields lower because how successful the Fed has been at ‘fending off’ financial crisis’s over the last two decades - but I digress. Lastly, and as if to subtly hint that he does not approve of what is going on in the bond market, Greenspan (throwing his hands in the air) uttered, “For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”
It is worth noting that Greenspan is absolutely correct: not only has the action on the long side of curve since June 2004 been unforeseen, it is also a conundrum: ‘historically (distant) forward rates have tended to rise in association with monetary policy tightening.’
That being said, rather than argue that ‘it will be some time before we are able to better judge the forces underlying the recent [interest rates] experience’, the investor should remember Occam’s Razor, and not make more assumptions than the minimum needed. Accordingly, in order to answer the interest rate conundrum a simpler question should first be asked: what has the impact of low long-term U.S. interest rates been? Remembering that that as long-term interest rates fall mortgage rates fall, Greenspan has this question covered:
“The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal saving rate to an average of only 1 percent over 2004--a very low figure relative to the nearly 7 percent rate averaged over the previous three decades. Among the factors contributing to the strength of spending and the decline in saving have been developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth.” Greenspan
Expanding upon the ‘household wealth’ theme, it is easily observed that falling interest rates have had a positive impact on not only the housing market, but also GDP. To be sure, when the U.S. economy was expanding strongly (2Q03-3Q03) mortgages were being refinanced to the tune of $800+ billion a quarter. This unprecedented explosion in refi activity is what (to paraphrase Greenspan) helped the U.S. consumer to save less and spend more.
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With the impact of falling interest rates known, the question becomes what would happen if long-term interest rates rose strongly? Fortunately, the historical correlation between rising interest rates and refi activity is not - and cannot be due to mathematics (i.e. a 6% mortgage cannot be refinanced at 7%) – at all ambiguous: rising interest rates would eventually depress refi activity.
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The hot housing market is a topic that has been covered at great length. As such, it is surprising that Greenspan didn’t mesh his housing remarks into his interest rates speculations. If Greenspan believes that the housing market is what has enabled the consumer to keep spending, why doesn’t he suggest that the fear of the consumer spending less (because of a depressed housing market) is what is keeping long-term interest rates low?
“Of course, household net worth may not continue to rise relative to income, and some reversal in that ratio is not out of the question. If that were to occur, households would probably perceive the need to save more out of current income; the personal saving rate would accordingly rise, and consumer spending would slow.”
Suffice to say, instead of pointing out the obvious – that long-term interest rates have remained low because as soon as they rise the housing market (and the consumer led economic recovery) is doomed - Greenspan suggested that economic expectations may be in decline ‘perhaps because of the rise in oil prices’. Rising oil is clearly a drag on economic growth (and could be why interest rates are not rising), but oil is also a negative that Greenspan can offer some even handed analysis on: “the share of total business expenses attributable to energy costs has declined appreciably over the past thirty years”. As for falling refi activity and/or a housing market implosion that forces the consumer to spend less and save more…there is no optimistic light that Greenspan can turn on this subject.
In short, falling interest rates (i.e. Greenspan) created the housing bubble and rising interest would (will?) pierce this bubble. Thus, while it is possible that investors are ‘excessively’ buying long-term U.S. debt, the investment should nonetheless pay off once mortgage activity cools off (or once long-term interest fall because the consumer stops spending and starts saving). Greenspan knows this, which is why he doesn’t mention it -- if Greenspan were to warn of the potential fallout from a housing crash how would he get the bond market to do his bidding? In other words, Greenspan wants higher long-term interest rates before the housing bubble grows even larger and/or before he has to invert the curve and spoil the party himself.
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