Dear Mr. Berko:
Can you explain why or how interest rates go down or up in simple economic terms that most can understand? And do you think as I do that rates will rise in the coming year or so, and how much? And if rates rise, how much will U.S. Treasury bonds fall? And finally, how can I invest money and make a profit when Treasury bonds fall in price?
C.S., Phoenix
Dear C.S.:
There is one certainty in the study of economics, which is the law of “Supply and Demand.” If demand for a commodity is constant, and the supply of the commodity is constant, the cost of that commodity in non-inflationary dollars will also be constant—that’s called “balance.” But when supply increases faster than demand, or if supply decreases faster than demand, that creates “imbalance.” Prices change, go into a dither, become imprecise and agitated—and the pot is stirred.
We know that interest is the cost to borrow money, and that cost is determined by the aggregate supply of money and aggregate of demand for that money. If supply and demand are in balance, interest rates will remain constant. If there is an imbalance in supply and demand, rates will fluctuate. And there are innumerable paradigms between supply and demand that affect balance/imbalance and determine borrowing costs or interest rates. I won’t enumerate, but suffice it to say, a computer-formatted spreadsheet can present thousands of difference scenarios that would keep a master statistician dizzy for a decade.
But so far, the Fed has done a yeoman’s job of increasing the money supply a little more than demand, and that slight imbalance has so far nudged interest rates to the lowest level in 70-plus years.
There are some checks and balances on how much more the Fed can safely raise the money supply before Congress or the administration screams “uncle.” But there seem to be no checks and balances on demand.
And I believe as you do that demand (congressional spending) will soon exceed the money supply and force costs (interest rates) to rise. I can’t tell you how high they will rise, but if the past is prologue, I would guess that the future rate on the 3.25 percent, 20-year Treasuries, currently trading at par, or $100,000 per bond, could be 6.5 percent in the coming two to three years. If so, the value of that bond, for illustrative purposes, would collapse to $50,000.
The math is simple. Today, to earn $3,250 in interest, you must invest $100,000 because rates are 3.25 percent. But in three years, if rates for the 20-year Treasury are 6.5 percent, as many expect, and you wish to earn $3,250, you only need to invest $50,000. Meanwhile, the old 3.25 percent Treasury would fall to $50,000 plus an added amortized appreciation as it approaches $100,000 maturity in the remaining l8 years.
There are several ETFs you can use to profit from falling Treasury prices. Rydex Inverse Government Bond (RYJUX-$13.25) and ProShares UltraShort Treasury (TBT-$39) are designed to be profitable as interest rates rise. Please counsel with your broker before you invest in either of them. Both give me agita. And, of course, you can really make a killing using derivatives and leveraging up the gazoo. That also gives me the willies.
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or e-mail him at mjberko@yahoo.com. Visit Creators Syndicate Web site at www.creators.com.
© 2011 Creators Syndicate Inc.
