Global calm brings a U-turn in rates

By , Staff writer of The Christian Science Monitor

Normality has been returning to the American bond market in recent weeks.

The crisis atmosphere that rattled world markets last fall after the Russian debt crisis and the failure of a huge hedge fund has faded.

Fearful investors fled for the safest investment of all, 30-year United States Treasury bonds. That sent their prices soaring and interest rates falling, to a record low of 4.72 percent Oct. 5.

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But as those fears of global collapse have subsided, interest rates have risen. For that reason, and others, the 30-year bond nowadays yields about 5.7 percent.

Further, the interest-rate spread between Treasuries and other less-safe bonds, such as those of corporations, has narrowed considerably.

"Brazil was the last shoe to fall, and now we see some healing," says Stephen Roach, chief economist, Morgan Stanley & Co., New York.

Here's what these bond developments mean for investors, experts say:

1. Those that bought Treasuries last fall have seen prices drop dramatically.

"You have been creamed," says Mr. Roach. A $1,000 bond bought then would sell for about $900 today.

2. A window of opportunity to refinance high-interest mortgages has diminished or disappeared with the rise in long-term interest rates.

The cost of a new mortgage has also gone up. Fewer families can afford to buy a house - or must settle for a smaller or less desirable home.

As a result, the sale of new homes in January was weaker than many economists expected. New home sales declined 5 percent to a 918,000 unit annual pace. Mortgage applications have plunged to their lowest level in a year.

3. Investors can get a better return on bonds. Millions of Americans own bonds, if not directly, through their Individual Retirement Accounts, or 401(k) or 403(b) retirement accounts.

"The rise in rates is not so bad a thing," says James Grant, editor of "Grant's Interest Rate Observer" in New York. With higher interest earnings compounding, bond investors will see their money grow faster over time.

The US bond market is huge. It includes $3 trillion of Treasury notes and bonds. Another $1.1 trillion in debt has been issued by other federal and federally sponsored agencies, such as the Federal National Mortgage Association of the Federal Home Mortgage Association. There are also trillions of dollars of corporate and municipal bonds.

Analysts figure the value of all these bonds is about equal to the value of all stocks - say around $11 trillion.

4. As the interest rate on bonds rises, that investment becomes more competitive with stocks.

As money shifts from stocks into bonds, both bond and stock prices fall, a factor in the recent weakness in stock prices, analysts say.

Since US government controls on international capital movements were ended during the presidency of Richard Nixon, the bond market has become gradually more international.

"You can't look at the bond market and just look at the US anymore," says David Wyss, chief economist of Standard & Poor's DRI, a Lexington, Mass. economic consulting firm.

International factors touching US bond prices these days include a huge flow of new government bonds in Japan to finance a massive deficit and support troubled banks plus lower interest rates in both Japan and Europe.

On the domestic side, faster-than-expected growth of the US economy has helped push rates higher.

"This new strength raised the question and some concern that the Federal Reserve might raise interest rates again," says Henry Kaufman, an economic and financial consultant in New York.

With no sign of renewed inflation, Mr. Wyss does not expect the Fed to act until the last half of this year. In the interim, the interest rate on Treasuries might settle at 5.25 to 5.5 percent, he says.

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