Friday, June 8, 2007

The Effects of Higher Interest Rates

The following is from Bloomberg and addresses some of the effects of realization by the market that rates could go up. The effect of this that still has not surfaced is the potential effect on the housing market. At this point the Fed has made it clear that its top priority from a monetary policy perspective is inflation and not housing.

The benchmark 10-year note extended declines after slumping yesterday by the most in more than three years. Debt markets in the U.S., Europe and Asia have been sliding since New Zealand unexpectedly raised borrowing costs yesterday, stoking concern other central banks will follow.

``It'd be dangerous to get in now,'' said Christian Zima, a fixed-income fund manager in Vienna at Raiffeisen KAG, which oversees the equivalent of $24 billion of bonds. ``The yield levels are starting to look attractive but sentiment is bad. There are further rate hikes getting priced in.''

Traders now assign a 44 percent chance the Fed will raise rates by 25 basis points by December, compared zero percent a month ago, according to options on Fed funds futures.

What a difference 5 days make, this was 41% just a few days ago.

The Federal Reserve has kept its overnight lending rate between banks at 5.25 percent at its last seven meetings. Policy makers will next decide on interest rates on June 28.

Bonds may be supported as stock markets in the U.S., Asia and Europe slumped on the expectations of higher rates, making yields on debt securities more attractive for some investors.

The spread between two- and 10-year note yields widened to 17 basis points, from 10 points yesterday. The yield on the two- year security climbed 1 basis point today to 5.04 percent.

It looks like the Fed may be forcing a more normal yield curve as opposed to the inverted to flat yield curve we have had for some time.

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