Tuesday, April 13, 2010

Uphill Climb

Interest rates.

As has been noted time and time again on this blog, the story of Vancouver Real Estate has been the story of interest rates... and as they go, so with R/E in the Village on the Edge of the Rainforest.

The stunning rise in land values in our humble utopia have been shaped by a historic 30-year decline in the cost of borrowing.

But as the New York Times noted on Sunday, consumers are about to face a new financial burden: a sustained period of rising interest rates.

It's a paradigm shift that is the inevitable outcome of ballooning sovereign debt levels and the renewed prospect of inflation as the economy recovers from the depths of the recent recession.

“[North] Americans have assumed the roller coaster goes one way,” said Bill Gross, whose investment firm, Pimco, has taken part in a broad sell-off of government debt, which has pushed up interest rates. “It’s been a great thrill as rates descended, but now we face an extended climb.”

The comments of Bill Gross are significant. He is a hugely successful bond fund manager and the co-chief investment officer of Pimco. He personally manages the company's flagship, the Total Return fund, which has $158 billion in assets.

Gross is highly influential and US Treasury secretaries call him for advice. Warren Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.

And with the collapse of Wall Street, Mr. Gross has emerged as one of the nation's most influential financiers.

In 1999, Mr. Gross warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross's fund ended 2000 up 12%, and that same year he and his partners sold Pimco to Allianz for $3.3 billion.

In an October 2005 letter to investors, Mr. Gross made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis.

And for Gross the next big financial story is going to be the tale of interest rates.

Gross sees the run-up in rates quickening as investors steer more of their money away from bonds and as Washington unplugs the economic life support programs that kept rates low through the financial crisis.

Mortgage rates and car loans are linked to the yield on long-term bonds.

Besides the inflation fears set off by the strengthening economy, Mr. Gross said he was also wary of Treasury bonds because he feared the burgeoning supply of new debt issued to finance the government’s huge budget deficits would overwhelm demand, driving interest rates higher.

Nine months ago, United States government debt accounted for half of the assets in Gross’s flagship fund, Pimco Total Return. That has shrunk to 30% now — the lowest ever in the fund’s 23-year history — as Gross has sold American bonds in favor of debt from Europe, particularly Germany, as well as from developing countries like Brazil.

And as other bond traders follow Gross's lead, the results are starting to impact rates.

Last week, the yield on the benchmark 10-year Treasury note briefly crossed the psychologically important threshold of 4%. Though still very low by historical standards, the rise of bond yields since then is reversing a decline that began in 1981, when 10-year note yields reached nearly 16%.

From that peak, steadily dropping interest rates have fed a three-decade lending boom, during which consumers borrowed more and more.

But those days are ending.

And for young home buyers today (who can consider 10-year mortgages with a stunningly low rate of just 5%), it is inconceivable that rates could migrate to those days of in the fall of 1981 when mortgage rates peaked at 21.5% in Canada.

And while few are willing to forecast rates to return to anything resembling 1981 levels, to those tuned in on Wall Street the question is not whether rates will go up, but rather by how much.

The consensus in the high level financial community is clear. As Terrence M. Belton, global head of fixed-income strategy for J. P. Morgan Securities, summarized, “everyone knows that rates will go higher.”

Just try telling that to anyone around this town.


Email: village_whisperer@live.ca
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