Don't Bank Much on Higher Interest Rates

Millions of people out there are cheering for higher interest rates. Call them un-American--they don't care. They feel they've suffered enough from skimpy returns on their CDs and bonds.

With each report that the economy is climbing out of recession, this group gets more excited. They figure a new economic boom is sure to mean 12% yields on Treasury bonds again, just like we had back in the early-1980s. Isn't that the way it always works?

Thus, many of these savers and investors are shoveling their cash into passbook accounts, money market funds and Treasury bills, just storing it up for the day that high rates come home again.

But here's the question these folks don't want to ask: What if rates don't rise in the 1990s?

There are many experts who now believe that there is virtually no chance of interest rates surging significantly in the years ahead, even as the economy recovers. At worst, these analysts see rates remaining in a narrow trading range through the mid-1990s as the United States shifts slowly from a nation of rabid young consumers to one of sober middle-aged savers.

So if you haven't begun to move some of your money into longer-term investments, the message is that it's time to do so.

Lately, yields on long-term Treasury bonds have jumped to 8.50% from 8.25% at the start of the year. That is partly what has got investors' interest-rate hopes up. Bond traders seem poised to push rates ever higher as they see more proof that the economy is rebounding.

But the evidence suggests that the rise in bond yields is temporary, says Robert Brusca, economist at Nikko Securities in New York. The long-term Treasury yield could briefly go a bit higher over the next few months--maybe near 9%--but Brusca believes that an 8.5% yield is "a fabulous interest rate" to lock in now "by any reasonable guess about inflation over the next two or three years."

Jerry Jordan, economist at First Interstate Bancorp. in Los Angeles, makes an even stronger case for 8.5% yields: "That's where I have my money," he says proudly.

Now, what do economists know? Here's the case for a no-worry interest rate environment in the years ahead:

* Low inflation follows tight money. Abby Cohen, investment strategist at Goldman, Sachs & Co. in New York, says the Federal Reserve "has been very tight with credit for four years. They really haven't swayed from that."

Of course the Fed has cut interest rates over the last nine months, to cushion the recession, Cohen says. But overall the Fed has remained vigilant about keeping interest rates up since 1987. And when credit remains tight, inflation historically has remained in check for years afterward. Simply put, the Fed has made sure that too many dollars haven't been chasing too few goods, which is the basis for inflation.

* The economy isn't going to boom. A fast-growing economy would mean much more demand for money and thus higher interest rates. But look around, says Brusca. Yes, people are spending a little more at the mall and car sales are inching back.

Even so, there's no way consumers are going to go hog-wild again, he says. There are too many people out of work, too many layoffs still threatened and too many families still deep in debt from the go-go 1980s. "The consumer has shot his wad," Brusca says. And just to make sure consumers are kept in check, he figures many strained state and local governments will be raising taxes in the second half of the year to balance their budgets.

* The dollar is strong. One U.S. dollar buys 1.79 German marks now. At the start of the year, it bought just 1.50 marks. A strong dollar does two things--it makes foreign goods cheaper here, and it makes U.S. goods more expensive overseas. The result is the same: American manufacturers have to work harder than ever to keep their prices down. Another reason to expect low inflation.

* The population is aging. You can't fight demographics. An older population saves more money and spends less. "I don't think we're going to turn into Japan," Cohen says of U.S. consumers' savings habits, "but the savings rate will get better in the '90s." And as more money seeks a home in bonds, CDs and other investments, the companies and governments issuing those investments can pay lower returns.

You can see that the crux of most economists' argument for lower interest rates ahead is based on expectations of low inflation--maybe 4% or lower each year through the mid-1990s. That's key for investors to remember, because inflation is what you want to beat, and beat handily.

The attraction of an 8.5% bond yield is that it's 4.5 percentage points more than the expected annual inflation rate in the years ahead. Historically, that is a very handsome return. For investors who need income above all else--and don't care if their investment also returns a capital gain--yields in that 8% to 8.5% range should make people very happy down the road, say many experts.

And here's the clincher: Even if bond traders freak over signs of a strong economy in the months ahead, and push long-term yields over 9%, it can't last long. For one thing, such rate spikes become self-correcting as investors rush for them. As money piles in, yields fall back quickly. You'd have to be a real pro to time such a move.

What's more, with a presidential election next year, don't think for a minute that the White House is going to allow a rise in interest rates that could derail the economy. Lacy Hunt, economist at Hongkong Bank in New York, says the Treasury could simply decide to discontinue 30-year bond sales if rates jumped sharply. That would send more money looking for a home in shorter-term bonds, causing interest rates overall to flatten.

Finally, what about short-term interest rates? If you're waiting for them to rise, that's probably not a bad bet. They have fallen so low (thanks to the Federal Reserve) that a blip higher by the end of the year is likely.

But it won't be much, Jordan says. Maybe three-month Treasury bill yields rise to about 6% from 5.7% now. Rather than waiting for a move like that, you're much smarter to begin moving more of your funds into those far more lucrative yields on longer-term bonds and other better-paying investments.

You still want to believe in 12% T-bond yields in a year or so? Forget it, Jordan says. He sees flat to slightly lower long-term rates all the way to 1995. As one of his staffers said of Jordan's interest rate forecast, "It looks like a walk across Kansas."

The Search for Yield

Sick of earning 6% or less on bank CDs? Here's a look at yields on various income investments, and how rates have changed over the past six months.

Annualized yield Investment Jan. 1 Now Money market mutual 7.16% 5.48% fund, 7-day average 3-month Treasury bill 6.64% 5.75% 1-year bank CD, 7.35% 6.16% national average 2-year Treasury note 7.27% 7.04% 5-year Treasury note 7.79% 7.96% 10-year Treasury note 8.08% 8.33% Corporate AAA bonds, 9.04% 8.98% average yield 20-year muni bond, 7.14%* 7.06%* Bond Buyer average 30-year Treasury bond 8.24% 8.51%

* yield is tax-exempt, so real return is much higher

Source: IBC/Donoghue's; Bank Rate Monitor; Federal Reserve Bank of St. Louis

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