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Interest
Rates and the Real World
By
Stephen J. Butler |
 Archives |
An animal trainer
interviewed on NPR years ago pointed out that dogs and cats are
equally trainable. The trick is to appreciate that dogs basically
want to please. Cats, on the other hand, are always thinking,"What's
in this for me?"
Last month's Federal Fund interest rate reduction prompts a look
at what this economic barometer signals to real people like you
and me. We know that Washington policy makers, like dogs, are
basically wanting to please the electorate. They are convinced
that reducing borrowing costs will stimulate the economy. For
those of us who make up the troops on the ground, the question
becomes, "What's in this for me?" Only after that question
is answered to our satisfaction do we unleash the stimulus the
policy-makers were hoping for.
So how about those interest rates? What behaviors do they trigger?
Starting with the interest-free car loan, we can compare it with
the typical "old" car loan that charged interest. A
$40,000 automobile (or fully-loaded pick-up truck) would have
cost $60,000 worth of car payments over a five-year period. That
extra $20,000 that would have been paid in interest can now be
spent on something else or we can invest it. Either use of the
money improves the economy.
Home refinancing to take advantage of lower rates has been like
an avalanche hitting the lending industry. People have substantially
reduced their mortgage payments by refinancing at lower interest
rates. Many have also taken the liberty of increasing their mortgage
to effectively spend some of the equity they had accumulated in
their homes.
Why not? It can make sense to be paying tax-deductible interest
costs of a net 4% (for most American taxpayers) if the equity
can be invested in, for example, one of the new tax-deferred college
savings plans that might compound at 7% or more.
Low interest rates also help to prop up home values. Alan Greenspan
mentioned in a recent interview that he was pleased with how robust
the housing industry appeared to be. Low interest rates make it
possible to sell houses for high prices. The ability to make monthly
payments is what qualifies us for home loans and effectively determines
the pricing of homes.
When will interest rates rise again? Our best answer to that question
comes from professional bond traders, not economists. Bond traders
are the tealeaf readers of the financial world. While nobody can
predict interest rate movements with any certainty, I would choose
a bond trader if I had to go to any one source. Unlike economists,
the traders are playing with real money--their own and their clients'.
Because they have more at stake, their instincts and analysis
may be more sharply honed.
Traders had already anticipated last month's drop in the Federal
Reserve rate from 2% down to 1.75%. We know this based upon the
price they pay for futures contracts. This is the commitment to
buy bonds at some point in the future that will pay a given rate
of return. This is an important indicator, because while it accurately
predicted last week's decline, these futures contracts are also
indicating that interest rates by June will be back up to 2.2
percent. After that, the indication is that they will remain constant
at a relatively low rate for the foreseeable future.
According to Jonathan Fuerbringer, in a New York Times article
on December 2nd, the federal funds rate remained at its low for
17 months back during the '90-'91 recession. As a general rule,
the rate has not been raised until after the unemployment rate
has peaked, and even then there tends to be a three-month lag
time. This means that a meaningful rate increase may not happen
until sometime in 2003. It also means that you can wait awhile
before feeling a need to take those calls from mortgage companies
during the dinner hour.
Meanwhile, the search for investment returns leads us to some
thoughts from Warren Buffett in last month's FORTUNE. He talks
about why he thinks the stock market will be averaging about 7%
annually for the next 10 to 20 years. He is a firm believer, of
course, in the "reversion-to-the-norm" school. This
holds that the market still needs to correct for the blowout of
the 1990s. However, the fact that this icon of conservative, successful
investing predicts 7% returns is, in my mind, very encouraging.
Money compounding at an annual 7.2% doubles every 10 years. If
we have better luck than Buffett predicts, and our money compounds
at 10%, it will double every 7.2 years. With 2% inflation anticipated,
these returns represent real gains.
When it comes to alternatives, nothing beats common stocks. Money
market rates are so low today that they barely cover the annual
expense ratios required to operate the fund. We may see a return
to post World War II short-term rates that were almost zero.
In short, we need to wean ourselves away from the high expectations
left by the roaring '90s. Even the spectacular stock market gains
of November/December may be nothing more than Wall Street's effort
to sink the hook once again. What we know for certain is that
interest rates are low and will stay that way for a while. This
affects us positively, and should lead to a careful consideration
of "What's in this for me?" We're probably not as smart
as our cats, but at least we should be asking their favorite question.
The securities
markets are subject to the risks of fluctuating prices and the
uncertainty of rates of return and yields inherent in investing
and past performance is no guarantee of future results.
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