Rising interest rates could threaten recovery

John W. Schoen Senior producer • Profile • E-mail

As the U.S. Treasury continues to churn out hundreds of billions of dollars of fresh debt, officials are confronting one of the thorniest problems since the financial crisis began.

Who’s going to buy all this paper? And if demand dries up, how much higher will interest rates have to go to attract new buyers?

The question is not just academic. When the crisis first hit last fall, investors worldwide sought shelter in U.S. Treasuries, and interest rates plunged. That helped to shore up battered banks and restart the housing industry with low mortgage rates

But now, as the financial crisis seems to have waned and the global economy shows signs of recovering, interest rates have begun rising, or "backing up." Any further rise in rates could throw cold water on the economy, boost the cost of mortgages and other loans and push back the recovery that many forecasters are looking for before the year is over.

“Along with declining home prices, those (lower) interest rates were key to reviving housing demand," said Thomas Higgins, chief economist with the Los Angeles investment management firm Payden & Rygel. “That's a key risk for the latter part of the year. We know where the crisis began, and it began in housing. And we need housing to recover.”

Though home sales have perked up this spring as mortgage rates fell below 5 percent, the 30-year fixed rate recently reversed course, rising to 5.29 percent this week — up nearly four-tenths of a percentage point from a week ago, according to Freddie Mac.

Fed officials say they are committed to keeping rates low, but it remains to be seen how far it can defend its target in the global money market. The central bank typically manages only short-term lending rates used by banks for overnight loans. Since the financial crisis hit last fall, the Fed has embarked on a bold experiment to push down longer-term rates by wading into the multitrillion-dollar global market for Treasuries.

The Fed’s task is made more complicated by the hundreds of billions in fresh debt paper the Treasury is churning out to finance the economic stimulus package, plug the growing hole in the federal budget and roll over the huge pile of past government borrowing that comes due every quarter. To attract investors to buy those bonds, the Treasury pays interest rates based on the lowest bids at auction. If investors demand higher rates, the cost of all long-term borrowing goes up.

“The government is keeping these rates lower and there are no legitimate, long-term real buyers of size to handle these auctions and the mortgage product that's being produced to try to stimulate the economy,” said Rich Berg, CEO of Performance Trust Capital Partners. "So (rates are headed higher) unless Uncle Sam is going to finance the whole thing for the next 20 years, which is not going to happen."

That’s one reason Treasury Secretary Timothy Geithner went to China this week: to drum up continued demand for U.S. debt. The worry is that if China loses its appetite for Treasuries, rates could move even higher.

“We actually have some experience of what happens when China stops buying because China stopped buying agency bonds and Freddie and Fannie bonds last fall, and for a brief period (rates) on agencies went up significantly,” said Brad Setser, a fellow at the Council on Foreign Relations and recent author of a paper, "If the Dollar Plummets." “And those rates only came down when the Fed started buying. So if you lose a big buyer, it does have an impact on the market.

As suggested by Setser's paper, foreign investors and governments are also worried about the impact of the surge in U.S. borrowing on the value of the dollar.  A falling dollar can hurt the value of existing Treasury holdings.

In his trip to China, Geither also sought to reassured Chinese leaders that the U.S. is serious about paying down this new borrowing quickly and that the Chinese government’s $760 billion investment in dollar-denominated debt is safe.

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