A Double Dip to Enjoy: Interest Rates

Tuesday, July 13, 2010

There continues to be an ongoing discussion about the economy potentially double dipping (AKA a repeat performance of the 2007-2008 bad times). Along with that worry is the stock market plummeting, with some pundits predicting a calamitous plunge. (I think Robert Prechter holds the current record with his Dow Jones Industrial Average forecast of 1,000 – a 90% crash.)

Meanwhile, a double dip in interest rates has occurred and, unlike the other discussion, this fact has positive implications with potentially good outcomes.

What’s happened to interest rates and why

Last fall, interest rates hit lows, then began a fairly steady rise as the economy continued to recover. As the US government raised new money (supply), corporations also issued new bonds (supply) in record amounts to capture the low rates. Investor moves (demand) from safer bonds to riskier investments affected rates. Moreover, the Federal Reserve was reaching the end of its bond buying activities (demand), and there was a growing expectation that it would begin increasing short-term rates.

This spring saw a reversal as economic worries and stock market declines brought investors back to those safer bonds while corporate issuance had fallen back. The declining rates produced bond price rises, influencing even more investors to buy bonds or bond funds. At the same time, expectations grew that the Federal Reserve’s would not be increasing rates anytime soon.

Here is the graph of three key long-term rates: 10-year US Treasury bonds, Aaa (highest rated) corporate bonds, and Baa (lowest of “investment grade” rated) corporate bonds.

The potential outcome of the low rates

With individual and institutional investors happily buying bonds, the government and corporations are able to take advantage of the low interest rates. Even individuals can take advantage. For example, see my article, “The New Housing Subsidy: Affordability” – July 6. The recent drop in the mortgage rate already has bumped up refinancings and could affect home buying this summer.

Even in non-investment grade (“junk” or “high yield”) bonds, things are looking good. For example, see “Junk Spreads Narrow as Economy Concern Fades: New Issue Alert” (Bloomberg BusinessWeek, by Katie Evans, July 12, 2010).

In other words, the low rates this time are probably having an even greater positive effect than last fall when the economy was only a few months past its bottom and uncertainty was high.

Forecast: Faster growth than expected

I recently read a respected economist’s forecast for “many years of very moderate growth.” With that as the expectation (some expect worse), the real potential surprise is for faster growth.

How could it happen?

  • First, the conditions are right (meaning the economy is operating fine at its current level without underlying problems and the financial system is doing well, with ample money at low rates to support growth).
  • Second, the starting point is low (the economy has excess capacity in both physical and human resources; lenders and borrowers have been conservative).
  • Third, history is on the side of fast growth. I cannot recall coming out of a previous recession when the prevailing forecast of slow going wasn’t proven wrong by surprisingly robust growth. See my article “Forecasts of Slow Growth May Be Incorrect” (October 13, 2009) for an explanation of underlying growth drivers when coming out of a weak economy.

Deflation – Not to be feared

To those who see bad in every new economic reading (e.g., it’s either the Euro dropping or the US dollar dropping, each with negative implications), the decline in interest rates indicates coming deflation. After all, we’ve just been through rough times reminiscent of the Great Depression, and that had deflation.

The problem with that logic is that it ignores the many differences, especially what the Federal Reserve and Congress are doing with the money supply. At the beginning of the Great Depression, the government retrenched, turning off the money printing presses while increasing the tax rates to try to balance the budget. Clearly, that was a lesson learned, and this time the government expanded, pouring money into the financial system and economy.

With the large increase in government money and bond issuance, the future challenge likely will be controlling inflation and maintaining the value of the US dollar. Therefore, deflation appears to be a low probability.

So… Today’s return to last fall’s low interest rates should have some widespread beneficial effects, including helping the economy to grow more quickly than expected in the future.

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John Tobey on Seeking Alpha

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July 2010