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Economic trends.

Several years ago at MBA's Senior Executives' Conference in New York City, Dick Hoey, Then chief economist with Drexall Burnham, indicated that he believed a recession was in the cards and that long-term interest rates, such as the rate on 30-year government securities, could drop to near 7 percent. The interest rate predication was a very bold one at that time, when the government bond rate stood at about 9 percent, but it turned out to be prescient.

At this year's conference, Hoey did not express such an optimistic view. Indeed, he argued that rates would probably bottom by March. However, Neal Soss, chief economist with First Boston, spoke of long-term rates dropping into the 6 percent range within the next several years because, in his view, there has been a fundamental and lasting change in consumer and business psychology, particularly with regard to inflation expectations and debt.

Fundamental to all of this is what factors determine the level of long-term interest rates. Economists have long argued about the details, but a number of key factors tend to emerge. These factors include:

* inflation expectations; * the money supply; * federal budget deficits and debt; * foreign capital flows; * U.S. economic performance.

Let's discuss each of these in turn.

Inflation expectations--Inflation is a critical factor in bond market performance because the purchasing power of money falls over time if the inflation rate is greater than zero. Investors are well aware of this and require yields that take expected future inflation rates into account. For example, if all goods and services are expected to increase in price by 10 percent in the next year, investors are not likely to make one-year loans below 10 percent. If they did, they would not be keeping even with inflation and would be unable to purchase the same things one year in the future that they can purchase today (i.e., their real purchasing power would decline). The same principle holds true at longer maturities, but the inflation expectations cover the anticipated holding period (e.g., as long as 30 years in the case of long-term government bonds).

The upshot is that if other factors affecting interest rates do not change, a rise in inflation expectations will push interest rates up, while a fall in inflation expectations will have the opposite effect.

The money supply--The supply and demand for money have strong influences on interest rates. The Federal Reserve (Fed) controls the money supply by injecting and draining reserves from the banking system, primarily through purchases and sales of government bonds. Other things being equal, an orderly increase in the money supply will exert downward pressure on interest rates; a decrease in the money supply will exert upward pressure.

An important qualification to these general relationships is that investors sometimes fear that an increase in the money supply is too large and may be inflationary down the road, thereby driving up inflation expectations and interest rates. However, if inflation expectations do not change, an increase in the money supply will exert downward pressure. The balance between just enough money supply growth and too little or too much growth is an ongoing challenge for the Fed.

Federal budget deficits and debt--Deficits must be financed. When they are, they add to the enormous sea of federal debt, and compete for funds in capital markets.

Other things being equal, increases in the deficit and debt will put upward pressure on interest rates, while decreases will put downward pressure. Further, because markets are extremely sensitive to expectations, tax and spending policies that portend lower deficits will decrease rates almost immediately, while the reverse also holds true.

Foreign capital flows--Capital markets are now truly global markets. Consequently, the behavior of foreign interest rates, the exchange value of the dollar and foreign investors' expectations all play key roles in determining U.S. interest rates. For example, if foreign interest rates are significantly lower than U.S. interest rates, and the exchange value of the dollar is relatively stable, foreign capital will flow into the U.S., helping put downward pressure on U.S. rates.

The importance of expected changes in the exchange value of the dollar is a bit more difficult to explain. If U.S. interest rates are relatively more attractive than foreign interest rates, foreign investors still may hesitate investing in U.S. securities if they believe their currency will rise in value compared to the dollar. The reason is that U.S. securities pay interest in dollars that must be converted back to the foreign investors' currency for that investor to use the proceeds. If the foreign currency is strengthening relative to the dollar, some of the value of the dollar-denominated interest flows will be undermined. Moreover, the foreign investor would suffer a capital loss upon the sale of the U.S. security. The reverse scenario also holds.

The upshot is that foreign capital flows are dictated by a complex interaction of factors, but are clearly extremely important in determining U.S. interest rates. There is little doubt that a major reason federal budget deficits did not drive U.S. interest rates through the ceiling in the 1980s is that there were massive inflows of foreign capital.

U.S. economic performance--The performance of the U.S. economy is not entirely independent of the factors already mentioned. Still, it is important to recognize that the cyclical position of the economy has a strong influence on where interest rates are headed. For example, if the economy has grown strongly for a number years and is approaching its productive capacity, further signs of growth are likely to put strong upward pressure on interest rates through increased demand for credit and investor concerns that an inflationary environment is in the works. On the other hand, if a recession appears likely, interest rates are likely to drift downward in response to lower inflation expectations and reduced demands for credit.

So these five factors--inflation expectations, the money supply, federal budget deficits and debt, foreign capital flows and U.S. economic performance--largely dictate where long-term interest rates are headed. If inflation expectations do continue to grind down in the 1990s, and if the Fed does not clamp down too severely on credit, and if deficit reduction re-emerges as a viable likelihood, and if foreign capital flows to the U.S. do not dry up, and if the U.S. economy does not begin to boom, or at least some of these things happen to offset factors putting upward pressure on rates, we may end up seeing long-term interest rates considerably below where they are now.
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Author:Holloway, Thomas M.
Publication:Mortgage Banking
Article Type:Illustration
Date:Feb 1, 1992
Previous Article:Secondary market.
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