Rate Cycle as Natural as the Tide

By Allan Sloan
Tuesday, May 23, 2006

One of Wall Street's favorite sayings is that you don't know who's swimming naked until the tide goes out. Now, thanks to Alan Greenspan and Ben Bernanke, we're starting to see some skin. That's because the present and former chairmen of the Federal Reserve Board have boosted short-term interest rates by a whopping 4 points in the past two years, leaving folks ranging from financially stressed homeowners to zillionaire hedge fund managers feeling a bit overexposed.

These higher short rates -- combined with higher long-term rates, which are set by financial markets rather than the Fed -- are finally starting to ripple through the economy to the detriment of borrowers, but to the benefit of savers. Since all of us are borrowers or savers, or both, herewith is a brief interest rate primer. No, I'm not going to burden you with discussions of Fed policy or the supposed significance of an "inverted yield curve" (when short-term rates are higher than long-term rates) or other technical stuff that causes the average eyeball to glaze over. Instead, let's just talk about some aspects of how the world has changed and what to make of it.

Housing first. For years, people warned about the dangers of financing houses with interest-only mortgages tied to short-term rates. But rates stayed down, prices rose, buyers were ahead. Even when rates headed up, housing prices in many markets kept on rising. One reason is that ever-more-

inventive mortgages requiring ever-smaller cash outlays put houses within reach of buyers who otherwise couldn't have afforded them. The idea was that when the "teaser rate" on your loan expired, another lender would want to tease you, and all would be well. But teasing isn't working anymore.

People who reached further than they could afford for low-cash mortgages -- which Minneapolis investment guru Steve Leuthold calls "financial death traps" -- now find themselves on the beach. "Rates on those loans were 4 percent two years ago, and now they're 8 percent," says Leuthold, "so your payment has doubled." Can higher foreclosures be far behind?

I expect house prices to drift down -- but not to crash. Here's why. The Greenspans and Bernankes of the world don't care what happens to you or me as individuals if we choke on too much housing debt. But they don't want millions of us to default on our mortgages en masse, because that could shock the financial system -- and the Fed's job is to protect that system. Regulators can do what they did in the early 1990s to avoid having to close giant banks that were underwater: use their discretion. I think even if rates keep rising, we'll muddle through, avoid anything resembling a foreclosure crisis and end up with a soft landing.

Not only are small-fry home buyers being affected by rising rates, but so are the big-fish hedge fund managers. Hedge funds as a group are having trouble posting the outsize returns they need to justify their high fees. The conventional explanation is that more hedge funds and more money are competing for the same deals, which drives down returns. But Pimco Investments' Bill Gross, the nation's best-known bond investor, offers an additional, little-known explanation: the end of cheap money. Leveraging an investment -- financial-speak for using borrowed money -- is a lot less lucrative when you're paying lots more interest. "Hedge funds are just unregulated banks," Gross told me. "When the cost of their leverage goes up due to higher short-term rates, their margins are squeezed and therefore their returns are reduced."

For all the problems they're creating, higher rates have had two beneficial effects. The first is that higher U.S. rates make the dollar more attractive to foreign investors than it would be otherwise. Yes, the dollar's down rather sharply this year against the euro and the yen -- but it would have doubtless fallen more had rates not risen. Protecting the dollar isn't mentioned in Fed minutes about rate-setting. But we've seen dollar sell-offs on days when people thought the Fed was done raising short-term rates.

The second benefit is that savers are being rewarded, with money-market mutual fund investors getting multiples of the rates they got two years ago. In May 2004, the average taxable money-market fund yielded only 0.51 percent, says iMoneyNet. The firm says the yield's now north of 4 percent and will soon hit 4.5.

Okay. Higher rates mean the tide's going out. Someday, rates will come down, the tide will come in, and nude swimming will resume. It was ever thus.

Sloan is Newsweek's Wall Street editor. His e-mail issloan@panix.com.

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