Banking-sector profitability is benefiting enormously from the unusually large gap between short-term and long-term interest rates.

The current spread of 400 basis points between the yields on 30-year Treasury bonds and three-month Treasury bill is the largest on record.

Funding time deposits at between 3% and 3.5% and investing in bonds at yields of 6.75% and above is an effortless and low-risk way to make money.

However, a marked flattening in the yield curve seems inevitable during the next year. Unfortunately, it will most likely come from increased short rates rather than lower long rates.

Stratospheric Yields

The aggressive easing in Federal Reserve policy was intended to widen net interest margins and reduce the financial pressures on the banking system.

Nevertheless, the Fed and the administration have been dismayed that long-term bond yields have remained so high in the face of the lowest short-term rates in 20 years.

Past recessionary swings in interest rates suggest that the 30-year Treasury yield should have dropped to between 6.5% and 7% in the current cycle. However, the 30-year Treasury yield has so far been unable to sustain a drop below 7.8%.

The steepness of the yield curve has created a huge incentive for investors to extend the maturities of their fixed-income portfolios.

Indeed, individual investors have made massive transfers from deposits and money-market funds into bonds and bond mutual funds. It is significant that long-term yields have stayed high despite their flows.

Stumbling Block to Economy

The stubbornly high level of long-term bonds yields represents a stumbling block to a vigorous upturn in the U.S. economy. Capital spending decisions are driven by the cost of long-term rather than short-term finance. The same is true of residential housing.

For example, about 80% of new mortgages are at fixed rates tied to the level of long-term bond yields. It is no coincidence that housing activity softened after bond yields and mortgage rates edged higher during the first quarter of the year.

The economy rebounded strongly from the 1981-82 recession despite high long-term interest rates.

However, that economic cycle benefited from Ronald Reagan's strong fiscal reflation, private-sector debt burdens were far below current levels, and the commercial real estate sector was in relatively good shape.

The economy of the 1990s is saddled with severe structural problems and is much less able that the economy of 10 years age to cope with high interest rates.

Why Rates Are So High

Three key factors are primarily responsible for the sickness of long-term interest rates:

* Investors are skeptical about the long-run inflation outlook against the background of a bloated federal deficit and surging growth in central bank liquidity.

* Low private savings and the large federal deficit leave little room for increased private-sector credit demand. The market is discounting higher real interest rates as credit market pressures intensify later in the year.

* The restrictive monetary stance of the German central bank, together with the asset deflation in Japan, are exerting upward pressure on global real estate rates.

A Credible Strategy

The policy prescription for lower bond yields is clear. First and foremost, the Fed must ensure that it pursues a credible anti-inflationary strategy. Secondly, the festering problem of the federal deficit must be addressed.

Finally, the U.S. authorities should resist the temptation of dollar devaluation as a way to boost U.S. competitiveness. A firm dollar is the best way to insulate the United States from the effects of high overseas interest rates.

The Fed has to shoulder the entire burden of maintaining an acceptable rate of economic growth, even if that means making compromises on the inflation front.

For example, the dramatic reduction in interest rates during the past year has occurred against the background of an underlying inflation rate of about 3.5%, not the zero rate that the Fed seeks.

Future Loan Demand

The Fed's determination to reduce inflation will be signaled by the speed at which policy is tightened when M2 growth eventually accelerates. The recent depressed growth of M2 is inextricably linked to the weakness in private-sector credit demand and the banking sector's reduced need for deposits.

Loan demand will increase as the economic recovery takes hold, and the explosive rise in M1 during the past year indicates the potential for a surge in M2. A prompt Fed response will go a long way to building credibility in the markets.

Higher short-term rates need not lead to an increase in long rates if the Fed is perceived as taking a preemptive move against inflation. The federal funds rate rose by 350 basis points between March 1988 and May 1989, yet the long-term bond yield remained in a narrow trading range.

The large federal deficit and the persistent increase in the ratio of public debt to gross domestic product remain the main reasons to fear a rise in long-run inflation.

The central bank may be full of good intentions, but the inexorable increase in public debt burdens will create huge pressure to inflate at some point in the future.

The federal deficit outlook is clouded by considerable political uncertainty.

Politicians generally respond to the public mood. The failure to tackle the deficit largely reflects the lack of a national consensus to accept painful cuts in entitlement spending an increase in taxes. In the absence of that consensus, it is political suicide for politicians to support tough antideficit measures.

The failure of Congress to pass a balanced budget amendment to the Constitution was no loss. Politicians will always find ways to evade any legislative attempts to curtail spending unless they have strong voter support.

The best chance for progress against the deficit could conceivably lie with a "new broom" administration led by Ross Perot. But even that hope requires a major act of faith. In practice, it probably will require a severe financial crisis before voters and politicians accept the need for drastic action.

Long-term interest rates will decline if investors develop confidence that inflation will be sustained at rates of 3% or less for the foreseeable future. The lack of fiscal discipline stands in the way of such a development.

Moreover, the federal deficit leaves little room for private credit demand to increase without putting upward pressure on real interest rates. Any attempt by the Fed to keep policy easy in order to accommodate strong public and private credit demand would lead to rapid money growth and would undermine the Fed's credibility.

Banks should not assume that the yield curve will maintain its current steep slope. Growth does not have to rise much in a low savings/high debt economy before interest rates come under pressure.

The Consequences

The cost of deposits will increase as the economy gradually strengthens but long-term rates will not increase proportionately. The good news is that banks will find increased opportunities in consumer and corporate lending.

The bad news is that it will be difficult to sustain the economic expansion as interest rates increase.

Mr. Barnes is managing editor of The BCA Interest Rate Forecast, published by BCA Publications Ltd. of Montreal.

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