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Stop Worrying About Higher Interest Rates

Interest rates are on the upswing. The benchmark 10-year U.S. Treasury bond reached the 4% mark on Apr. 5, its highest level since October 2008. The yield has since dropped back a fraction below 4%, with investors once again seeking a safe refuge from financial turmoil—this time gnawing concerns that the Greek government will default on its debt. Nevertheless, the trend is toward higher long-term U.S. interest rates.

Is this good news or bad news? It all depends on what's driving rates higher. Of course, divining the whys and wherefores of bond yields isn't easy. When Campbell Harvey, economist at Duke University's Fuqua School of Business and editor of the Journal of Finance, was asked how to figure out what was behind the rate rise, he quickly quipped: "That's like asking what's the meaning of life." Nevertheless, he added, two major components will help you plumb the message in the Treasury yield curve: the expected rate of inflation and the expected real rate of return on Treasuries.

Nevertheless, a new factor is getting some play: the risk of government default. The debt obligation of the U.S. government is typically considered the foundation of the global capital markets. Yet there have been mutterings about the unthinkable happening in the wake of the federal government's massive borrowing boom, the future tab of entitlement spending, and the lack of bipartisan problem solving. The current unpleasantness in Greece, to this way of thinking, is simply a harbinger of America's future.

Escape Hatch

The default fear is kind of silly, however. The Greece government doesn't own a printing press, and it could default if it can't pay its bills. In sharp contrast, default risk is really the same thing as inflation risk in the U.S. "The U.S. can always pay its debts," says Harvey. "We can print money." That's not necessarily a good thing, of course, as the so-called monetization of the U.S. debt would debase the currency and destroy wealth.

Critics have worried that the U.S. economy would reach a pivotal moment in which the ultraloose monetary policies of "Helicopter" Ben Bernanke would end in a bout of virulent inflation. (The Federal Reserve chairman was unfairly tagged with the nickname Helicopter Ben after he mentioned in a 2002 speech that the central bank could combat deflation by essentially handing out cash to the public. The reference actually came from Nobel laureate Milton Friedman's famous monetary policy metaphor of a "helicopter drop" of money.)

But that case is weak, at best. Investors aren't especially worried about inflation. For one thing, the core rate of inflation—the consumer price index minus volatile food and energy prices—has averaged a mere 1.3% over the past 12 months. The core rate of inflation typically decelerates for 12 to 24 months after a recession ends, which could put it below 1% a year from now. Even more striking is the inflation rate predicted by the Treasury market over the next 10 years: 2.34%. The 10-year Treasury Inflation Protected Security (TIPS) currently yields about 1.55%—or 2.34 percentage points less than the 10-year Treasury of similar maturity that doesn't offer investors a built-in hedge against rising prices.

Why It's a Positive Sign

No, despite widespread pessimism among the chattering class of cable TV and the political marketplace, the yield is sending an optimistic signal. Investors are shedding their worries about a faltering economy or even a double-dip recession. The stock market is up sharply, consumer spending is picking up, manufacturing is doing better, and even housing and autos are probably near bottom. The economy is gaining momentum.

What's more, the rise in rates could be good for corporate profits and the stock market. Yes, it's true that everything else being equal, higher interest rates hurt stocks because a rise in borrowing costs can eat into future profits. In addition, higher rates usually hammered stocks from the late 1970s to the late 1990s, because rising rates were considered a signal that inflation pressures were getting out of hand. That relationship, however, broke down in 1998, according to James W. Paulson, chief investment strategist at Wells Capital Management. Deflation, or a fall in the overall price levels of goods and services, started to grab investor attention around then. Japan became a deflationary economy in the early 1990s. The dreaded D-word also created havoc elsewhere: The Asian meltdown of 1997, the Russian financial crisis of 1998, the bust, and the Great Recession all created deflationary pressures.

"Not only are interest rates low, but because deflation risk remains widespread, the stock market may continue to advance much longer in the face of rising yields than most anticipate," says Paulson.

The big surprise could be how fast the Fed shifts gears and hikes its benchmark interest rate, which is currently at zero. When it does, investors will cheer, because it will confirm that the recovery is here. And savers may finally get a decent rate of interest on their investments.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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