Highly curious about low interest
Dear Mr. Berko:
I haven’t seen this question in your column for some time, but can you tell me how long these low interest rates will last? Do you think they’ll stay this low for another five to 10 years? Can you talk to some of your contacts at the Federal Reserve and give readers an idea what the Federal Reserve will do about rates in the next few years?
I have $100,000 to invest in bonds and I can buy long-term, 30-year U.S. government bonds that pay 3.5 percent. Those bonds seem like the safest around. Can you tell me what will happen to the value of this bond if, one year from today, Alan Greenspan raises the 30-year rate to 5.5 percent? Do you think I should invest this $100,000 now, or wait six months to a year before I make investment? I don’t want to take a chance on these rates moving much lower. Please advise as soon as you can.
W.A., Delray Beach, Fla.
I don’t know why you and a number of other readers seem to think that I have a mole inside the Federal Reserve Bank. Be mindful that I don’t know a soul who works at the Fed.
I cannot tell you if the Fed, which rules our economy, will raise rates, allow them to remain where they are or lower them.
I guarantee you that interest rates will move higher. I just can’t tell you when it will happen. At some point, after rates have moved higher, they will move down once again. But of course, I can’t tell you when.
Interest rates are sort of like the barometric pressure of the economy. One can, with good certainty, forecast where rates will be tomorrow, next week and maybe next month. The reliability of a forecast, however, declines as you extend your time line, just like weather prediction.
The best guess I can give you is that interest rates may remain low for the remainder of 2003 and possibly the first half of 2004.
For your second question, assume that today you paid $100,000 for a 3.5 percent U.S. Treasury bond that matures 30 years from now. That bond would provide you with a $3,500 a year in interest income.
Now let’s jump to a year from now. Because this year’s federal deficit is now a record $450 billion (send a thank-you note to your Congressman), the government has to pay 5.5 percent on its new 30-year Treasury bonds to attract new buyers. That would mean you got shafted.
Under this scenario, that $100,000 you invested last year to get 3.5 percent isn’t earning this year’s 5.5 percent.
The market value of the 3.5 percent Treasury bond you bought last year is going to plunge. In fact, the market value of that 30-year, 3.5 percent U.S. Treasury bond will derail all the way down to $63,625, so you’re 20 years behind the finish line and $36,375 poorer.
The math is simple. A year ago you invested $100,000 to earn $3,500, which is a 3.5 percent current yield. Today, that same $100,000 will earn $5,500, or 5.5 percent current yield. So the question is, how low must the market value of the 30-year, 3.5-percent Treasury bond decline so the $3,500 in interest income yields 5.5 percent to a new buyer?
Without doing the calculus, Treasury bonds (the highest quality bonds in the world) will plummet in market value to $63,625, because that amount invested at 5.5 percent earns $3,500 in interest income.
You would have to buy $157,100 face value of 3.5 percent U.S. Treasury bonds to earn $5,500 in interest income. Be mindful that if you buy $157,000 face value bonds at $636.25 per $1,000 bond, you will have paid $100,000.
I think rates will probably hover at the current level (give or take 50 basis points) until the November 2004 elections. After the presidential elections, interest rates have the potential to ratchet up a lot higher. So rather than allow your $100,000 to earn zilch in a money market account, check the banks, buy an 18-month or two-year certificate of deposit and just sit back and wait for higher rates before you invest your $100,000 long-term.
Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at email@example.com.