We’re facing an important inflection point in the stock market. And as always happens at such critical times, investors are likely to get bamboozled by misinformation that they get from the mainstream media. I’m going to try to straighten some of that out.
All eyes are focused on interest rates. A couple of months ago, Treasury bond yields were touching half-century lows, but since then they’ve shot up in one of the most volatile moves on record. Mortgage rates are following. And the Federal Reserve — which until recently was expected to keep short-term rates low virtually forever — is now expected to raise rates again within the year.
The media are barraging investors with the message that higher interest rates are a disaster. Now that the economy is beginning to show real signs of recovery, investors are being told that higher rates will slap the economy back down again. I’m tempted to say that the media couldn’t be more wrong — but I’m sure someday they’ll find a way.
You see, when it comes to interest rates and the economy, the conventional wisdom expressed in the media has it exactly backwards. The economy doesn’t revolve around interest rates any more than the sun revolves around the earth. It’s just the other way around: The earth revolves around the sun, and interest rates revolve around the economy.
When investment opportunities in the economy are attractive, people will be willing to pay more to borrow the money that will allow them to take advantage of those opportunities — so interest rates will naturally rise. But when investment opportunities are poor, people won’t be willing to pay as much to participate in them — so interest rates will fall.
When interest rates change with the economy, different people are affected in different ways depending on who they are. When rates fall in a stagnant economy, homeowners can reduce their mortgage payments — they’re winners. But at the same time, people dependent on money-market investments suddenly find themselves with less income — they’re losers. Over the whole economy, things stay pretty much in balance.
So don’t celebrate low interest rates — they mean the economy is doing poorly. And when interest rates rise, don’t fear — it just means the economy is growing again. It’s really just that simple. Well, sort of.
It gets complicated when the Fed enters the picture, but the basic idea remains the same. The Fed gets in the way of the natural process of supply and demand that would normally cause interest rates to reflect perfectly the level of opportunity in the economy. When the Fed wants to stimulate a flagging economy, it has to set interest rates below their already low natural level. That way people will borrow money to undertake opportunities that would otherwise be uneconomical — and that’s supposed to get the economy moving again.
When the Fed does that, it’s providing a financial crutch to an economy that, it believes, can’t walk without it. The Fed has been supplying that crutch for about a year now, and it’s part of what has helped the economy to recover as much as it has. But there comes a time when the patient gets well, and must walk on his own again — and that’s when the Fed should take the crutch away. So if interest rates go up when the Fed crutch is withdrawn, isn’t that good news?
Taking the Fed into account, there are two reasons — two good reasons — why interest rates rise when the economy begins to recover. One is that increasing growth opportunities in the economy drive up the natural interest rate, and the other is that the Fed stops keeping rates artificially low.
So why, then, do we read so many stories in the media about how higher interest rates will “choke the economy” and “stall the recovery” and so on and so on, ad absurdum. Of course it’s because the media do not understand how the economy works. But it’s also something very basic and very human: Ailing patients will often get fond of their crutches, and find them difficult to give up even after they’ve healed.
Hasn’t it been great to have low mortgage rates? Hasn’t it been great to buy a new SUV with 0% financing? Yep, those crutches have been pretty slick.
But why stop there? There are all kinds of seemingly good things that happen in a recession. Roads are less crowded. You can get a table at a restaurant without a reservation. It’s a wonderful life — if you still have a job, and don’t mind the fact that you don’t seem to be getting a raise this year and that your 401(k) has been wiped out.
Me, I’d rather have high interest rates — along with crowded roads, busy restaurants and all the rest — if that means I’ll get my bustling, growing, vibrant economy back.
Don’t get me wrong. It’s not easy to get off those crutches and walk again. One difficulty is the impact on stock valuations. I’ve been saying here for months that stocks are cheap, in part because interest rates are so low (so future earnings and dividends can be discounted at lower rates). Now with rates higher, stocks are suddenly not so cheap anymore — and notice that they’ve stalled out pretty much over exactly the same period that rates have been rising.
But that’s just a temporary effect. If rising rates (added to the sensational stock rally off the March lows) have left stocks closer to fairly valued, I’m not worried. Sure, it reduces the value case for stocks. But at the same time, it adds to the growth case for stocks. Well, maybe not exactly “at the same time” — it will take a bit for weary stock investors to believe that the economic recovery that has driven higher interest rates will also drive more rapidly growing dividends and earnings. But it will happen.
No, rising interest rates aren’t a cause for concern — no matter what the media tell you. They’re not a cause at all. They are an effect — an effect of an economy that’s finally getting back up on its legs and starting to walk again. In a couple of months, let’s try some running!
— The above was an “Ahead of the Curve” column published August 8, 2003 on SmartMoney.com, where Luskin is a Contributing Editor.