Commentary

Higher Rates Reflect Higher Growth

This article was published in the Washington Times, Aug. 10, 2003.

Before Congress cut the tax on dividends and capital gains in May, critics claimed it would have little impact on the stock market. Yet stocks were already rising in April in anticipation of higher after-tax returns in the future. The rally to date has already been impressive, despite recent setbacks. The Dow is still up nearly a fourth from this year’s low of 7,286 on March 10. The NASDAQ is up even more.

Such conspicuous success embarrassed many who predicted failure. As usual, defensive themes soon emerged among financial reporters who specialize in looking for clouds behind every silver lining. Some claimed the market’s rebound was an inexplicable “mania” destined to collapse. Others tried changing the subject, putting undue emphasis on such notoriously misleading indicators as payroll employment and consumer confidence.

The most common journalistic device to convert investor success into political failure is to fret about the fact that long-term interest rates are up from their record lows. This often involves such quackery as pretending the bond market suddenly noticed budget deficits in August that it failed to see in June. And the supposedly unsettling news always involves ominous warnings that higher interest rates threaten the continuation of hectic mortgage refinancing. Refinancing is said to be critical to consumer spending, which, in turn, is ineptly described as the cause rather than consequence of prosperity.

This story is not new. On March 24, James Grant wrote in the New York Times: “Buoyed by war news and easy money, [the stock market] has strung together eight days of gains, the most since June 1997. But the bond market, too, has noticed. Interest rates have climbed, with the 10-year Treasury note now above 4 percent, up from a low of 3.56 percent only a few days ago. Mortgage rates have followed suit, a shift that imperils the glorious mortgage refinancing boom.”

By the end of that day, ironically, war news was more plausibly said to be the reason stocks suddenly fell 3.6 percent — pushing the Dow down to 8,215, while the yield on 10-year Treasury notes fell to 3.97 percent. That simultaneous decline in stocks and bond yields was also nothing new. Long-term interest rates had earlier bottomed when stocks did on March 10. In fact, bond yields then fell to the lowest level since October 2002, which (by no coincidence) was yet another record low for stocks.

Fears about the economy, in short, have often driven people out of stocks and into Treasury bonds. Falling stocks prices have often been associated with falling bond yields. So how can anyone now feign surprise when good news for the economy has the opposite effect — raising both stock prices and bond yields?

When long-term rates rise more than short-term rates, that is called a steepening of the yield curve. Such steepening of the yield curve is one of the most reliable tools economists have for predicting an improving economy. For one thing, a wider spread between rates on loans and deposits makes banks less timid about lending to small businesses.

Back in March, when Mr. Grant began worrying about rising bond yields, he imagined the bond market feared higher inflation. But that explanation is inconsistent with the rise in stock prices and, more recently, in the dollar. The stock market hates inflation, and the dollar generally goes down with inflation, not up.

The real reasons long-term rates recently backed up a bit were (1) they had been astonishingly low and (2) expectations of better business profits normally bid up real, inflation-adjusted rates. Higher interest rates can push price-earnings ratios down, but the beneficial impact of higher earnings is far more critical for stocks.

Journalists have revived Mr. Grant’s other idea, that a higher mortgage rate “imperils the glorious mortgage refinancing boom.” As someone who recently refinanced at 5 percent, I can confirm that I am certainly not planning on doing that again. Yet the glorious effects will nonetheless persist for years and years. Most who could benefit significantly from refinancing have done so, reducing their monthly living costs by several hundreds of dollars well into the distant future. This was no mere short-term “stimulus” that could now suddenly vanish unless there was more and more refinancing. On the contrary, refinancing has greatly reduced the burden of past debts and increased the share of future income left for consumption and investment.

Because most mortgages are fixed for many years, so are the benefits from refinancing. One little-noticed benefit even accrues to federal and state governments: Many taxpayers with smaller mortgage interest bills will now be claiming smaller tax deductions. That is one of many reasons I believe future deficit projections are too pessimistic.

A smart thing to do with some of that cash saved by refinancing would be to buy stocks on dips.

Many Americans who were excessively fearful of stock market bargains this spring ended up holding too many Treasury bonds at too low an interest rate. It was and is a far wiser idea to ignore all the gloomy financial writers with all their second-hand excuses for missing the market’s turn and pick up some bargain shares in this accelerating American economy.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.