What if interest rates don't rise?

chart_treasury_yield2_top.jpgBonds sold off Wednesday, but it may be a while before yields move return to pre-crisis levels.By Colin Barr, senior writer

(Fortune) -- Here's a shocker: It could be years before U.S. finances are jolted by an interest rate shock.

Some forecasters are banking on rising interest rates. The Federal Reserve has kept its key short-term rate near zero since December 2008, but many economists believe a rate hike could take place as soon as later this year.

Credit rating agency Moody's said last week the price the government pays to borrow money for five years will nearly double between now and 2012. It warned that rising debt costs could constrain government policy in coming years. A bond market selloff Wednesday only intensified those concerns.

Yet even with governments around the globe issuing new debt at a record clip, interest rates may stay low for some time. Risk-averse investors are seeking out income-producing bonds and policymakers around the world are struggling to shore up domestic employment.

That's good in the short term, as low rates would help extend the current recovery and ease one source of pressure on the stretched federal budget.

At the same time, some warn that stable interest rates could create a replay of the housing bust, by letting Congress put off overdue action on the deteriorating U.S. fiscal position.

"We might hope that financial markets would save us from catastrophe by demanding higher interest rates on Treasurys, but that would require a degree of foresight that we haven't seen lately," Syracuse University budget expert Leonard Burman told a House Ways and Means Committee panel earlier this week.

Indeed, market players are showing increasing confidence that rates won't rise any time soon. The spread on a 10-year interest rate swap, reflecting the price an issuer of floating-rate bonds might pay to lock in a fixed rate, turned negative this week for the first time.

"I keep expecting a normalization, but the market is convinced the Fed is not going to do it," said Howard Simons, a strategist at Bianco Research in Chicago, about when the Fed might boost short-term rates.

In part, that's because a sustained recovery isn't in evidence at the moment, to say the least.

Unemployment remains near 10%, and inflation -- widely considered the great threat arising out of government support for the economy -- is not only low but falling.

Consumer prices excluding food and energy rose just 1.3% in the year ended in February, the government said this month. That number is even lower if you look at the latest six months of data, said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington.

Anxious to avoid a replay of Japan's deflationary lost decades, the Fed could come under pressure in the second half of this year to expand its purchases of long-term bonds if the rate of inflation keeps falling, Gagnon said.

"The Fed is going to tighten much later than people seem to think," he said.

The Fed isn't the only factor. Two market crashes in the past 10 years have soured many investors on stocks for good. Huge sums of money have poured into bond funds over the past year, bolstering prices in the face of a massive increase in supply.

The bond vigilantes have visited Ireland and Greece, selling European bonds and pushing their rates higher. But some doubt they are in any hurry to lay siege to the market for U.S. government bonds. After all, they have to keep their money somewhere.

"To flee from something you need an alternative," said Simons. "Your alternatives now are what, exactly?"

What's more, policymakers both here and abroad have incentives to keep funds flowing into the United States.

Though U.S. borrowing and China's undervalued currency are widely viewed as unsustainable, the current arrangement suits both parties at a time when both fear any setback could halt a weak recovery.

"Rates may stay low because our foreign lenders have an incentive to keep enabling our borrowing habit," Burman told the House panel Tuesday. "The money they lend us fuels our giant trade deficit, which in turn props up their economies."

That cycle could ultimately lead to a re-enactment of the housing bust, in which the bond market remains placid until a crisis makes credit all but unobtainable -- ultimately forcing massive, indiscriminate government spending cutbacks and another economic downturn.

Even if it doesn't come to that, Japan's lost decades show that low-rate policies are far from foolproof. Japanese 10-year notes recently yielded 1.35% and haven't been above 2.15% in more than a decade, Simons noted.

"Did anyone think Japan would still be stuck here in 2010?" he asked.  To top of page