Why the U.S. budget deal might lead to higher interest rates

The new, bipartisan budget deal in Congress – crafted to avert another government shutdown – could have a ‘surprise’ effect: It could lead to higher interest rates in 2014.

  • The big reason is that it opens the door for the Federal Reserve to begin tapering its bond-buying economic stimulus. This fall, just before the shutdown, the Fed backed off on tapering, a move the market had already anticipated with higher interest rates. Part of the Fed’s reasoning was the budgetary gridlock and its possible effect on the U.S. economy. Now, with that threat apparently gone, the Fed has a freer hand to begin the tapering, which should in turn cause Treasury rates to rise.
  • Also the budget deal does nothing to slow down government spending, it just rearranges it. But it does soften the blow of coming sequester cuts to defense spending, which should in turn help the economy continue improving. This also opens the door to tapering.

From a Wall Street Journal report:

“The budget deal takes away uncertainty and the deal adds to spending marginally which should help economic growth be a bit stronger than expected next year,” said Thomas Roth, executive director in the U.S. government bond trading group at Mitsubishi UFJ Securities (USA) Inc. in New York.

I was surprised Wednesday that the TIPS market reacted to the budget deal with a yawn. The TIP ETF dropped about 0.1%, a meaningless move after trading slightly higher through the day.

But yields have risen noticeably as the budget deal became more likely. The 10-year nominal Treasury is yielding 2.86%, 12 basis points off the high for the year – 2.98% on Sept. 5. The 10-year TIPS is yielding 0.71%, 21 basis points off its high – 0.92% on Sept. 5.

So far, TIPS yields haven’t made a ‘giant’ move in reaction, but the trend is up. The 10-year inflation breakeven point stands at 2.15%, better than it has been recently.

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2 Responses to Why the U.S. budget deal might lead to higher interest rates

  1. so does that mean that government will pay more in interest on the national debt?……

  2. tipswatch says:

    Steve, that’s already been happening, with the yield on a 10-year Treasury rising from 1.66% in May to about 2.8% today. That’s still a low yield, I could see it rising another full percentage point next year. Treasury buyers will benefit, but in reality the Fed’s actions have been cheating Treasury buyers out of real interest rates for a couple of years.

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