Interest Rate Drop: Markets Fear Deflation & Recession, Not Deficit Spending

As 2010 began, there was nearly unanimous agreement in financial circles on at least one thing:

Interest rates were sure to rise during the year.

For good or ill, quite the contrary has occurred.

As Labor Day approaches, interest rates have collapsed, plunging along with economic optimism.

That turn of events, which has shocked savers and stunned investors, appears to indicate that

As 2010 began, there was nearly unanimous agreement in financial circles on at least one thing:

Interest rates were sure to rise during the year.

For good or ill, quite the contrary has occurred.

As Labor Day approaches, interest rates have collapsed, plunging along with economic optimism.

That turn of events, which has shocked savers and stunned investors, appears to indicate that

financial markets’ worries are turning in a very different direction from those of many governments.

The governments are seeking ways to bring down budget deficits,

fearing that without austerity they could go so far into debt that they would never be able to borrow again.

Investors in the financial markets seem to be much more concerned by the possibility of renewed recession

and a general deflation that could send asset values and prices down.

That market reaction is the opposite of what happened in the late 1970s and early 1980s.

Then “bond vigilantes” were reluctant to invest in United States Treasury securities because they feared runaway inflation.

Their refusal drove up the interest rates the government had to pay on its borrowings

and eventually led the Federal Reserve, under Paul A. Volcker, to wage war against inflation

even if it meant choking off economic growth.

Now, far from showing a reluctance to finance the American government,

investors are seeking safety and evidently believe American government debt is the safest possible investment.

They have rushed to send money to the Treasury, thereby reducing borrowing costs for the government.

By late 2009, interest rates had fallen to levels previously thought inconceivable.

The annual yield on a two-year Treasury note dipped below 1 percent. But it has since traded barely above one-half percent.

Perhaps investors are nervous because they fear governments will swing too far toward austerity.

When economies weakened three years ago, talk immediately turned to economic stimulus.

This time, much of the discussion in Washington, as well as in many European capitals,

has focused on the need to reduce spending and deficits,

rather than on the possibility that additional stimulus might be needed to avert a new worldwide downturn.

The new British government has announced plans for sharp spending reductions aimed at narrowing deficits and government borrowing,

even as the Bank of England has said the growth outlook is dimming.

Deficit hawks are leaning forward in the United States as well.

“Many Americans and most senators feel that the level of the federal debt is at crisis levels,”

Senator Lamar Alexander, a Tennessee Republican, said in a Senate debate last month, adding that

the debt “threatens the security of our country.”

Much of the new international worry about government spending was prompted by the Greek debt crisis this year.

It avoided default only with help from other European countries.

That aid was conditioned on Greece agreeing to a strong austerity program,

to be monitored by a group including representatives of the International Monetary Fund.

The I.M.F. has often prescribed austerity for countries in trouble,

but recently two senior officials of the fund sought to slow the push for spending reductions in major economies.

They challenged the perception that national budgets are in trouble

because of the bailouts and fiscal stimulus programs enacted to combat the financial crisis.

“Today’s debt problems,” wrote Olivier J. Blanchard, the chief economist, and Carlo Cottarelli, the fund’s head of fiscal affairs, in an essay published in The Financial Times,

“result not from how fiscal policy was managed during the crisis, but from how it was mismanaged before the crisis.”

Countries, they said, should have built up savings when times were good.

The two officials argued for restraint in imposing austerity programs now,

advocating the adoption of fiscal reforms that will have their largest impact in later years.

The problems that confronted Greece could not precisely replicate themselves in either the United States or Britain.

Both borrow in their own currencies, which they could print if others were reluctant to make loans.

It would be disastrous if either country got to the point that investors abandoned it,

or even drove up interest rates sharply by scaling back their support.

But precisely the opposite has happened this year.

That interest rates have declined is good news in many respects.

“There are,” said Sal Guatieri, senior economist at BMO Capital Markets,

“always people who have jobs who can take full advantage of lower interest rates to borrow and spend.”

But that impact now may be weakened by two factors, perhaps increasing the need for fiscal stimulus.

First, there are many who can not be helped.

Homeowners with ample equity and income can refinance their mortgages at record low rates,

which fell to 4.4 percent last week.

But millions of homeowners either lack sufficient income or have houses no longer worth what is owed on the mortgage.

They cannot refinance.

And while government borrowing costs have plunged in the countries deemed safest by investors,

they have risen in some others.

Germany now pays 1.4 percent on five-year borrowings, while Greece pays more than 11 percent.

The German economy is booming, while the Greek recession is worsening.

The second negative factor from lower interest rates now is harder to quantify, but may be of growing importance.

Those people who depend on their savings to provide income now earn far less from their thrift than they used to receive.

Some avoided sharp declines by purchasing longer-term certificates of deposit from banks.

But as those C.D.’s mature, the banks are offering low rates even on long-term deposits.

The growing disenchantment with government spending has led to talk of the world reaching a “Keynesian endpoint,”

as Anthony J. Crescenzi, a strategist for Pimco, a large investment firm, put it this summer.

At such a time, countries needing to rescue banks and stimulate their economies would be unable or unwilling to do so.

The Federal Reserve’s move, in which it committed to buying up a small amount of Treasury securities, showed its determination to act

but “may have exacerbated the fears,” said Dean Maki, the chief United States economist for Barclays Capital.

“The Fed seemed to have significantly downgraded its economic outlook,” but its policy change “appeared fairly minor in comparison.”

Lower interest rates are already helping some companies.

I.B.M. is paying only 1 percent to borrow $1.5 billion for three years.

And as some investors search for better yields, many companies are benefiting.

Earlier this month, a record $14.3 billion of new bonds were issued around the world

by companies with bond ratings LOWER than investment grade, Thomson Reuters reported.

At the same time, new stock issues have declined.

Still, stock prices are slightly below where they were at the end of 2009,

when many analysts expected a better recovery than seems to be unfolding.

The new concerns have manifested themselves more in bond prices than in stock levels.

Economics is a notoriously uncertain pursuit, according to this provocative analysis in the New York Times.

It is possible that a surprisingly strong employment report, or some other unanticipated event,

could begin to disperse the fog of economic pessimism that has engulfed investors and sent interest rates to record lows.

But for now, the financial markets seem to fear recession and deflation much more than they fear deficit spending.