The current debate regarding the U.S. economy revolves around the recent hike in interest rates as represented by the 10-year Treasury bond rate. This rate had spent most of the last four years dancing below 1.85 percent, which is considered very low by historical standards. Suddenly, this rate has risen to over 2 percent since last April. Although still historically modest, this jump has brought two related concerns in the capital markets regarding the health of the economy. Some pundits have read this increase as a sagacity of creeping higher interest rates, which by definition reflect changes in inflation expectations. Others see the increase in rates as a signal that the Fed’s quantitative easing, which has infused liquidity in the economy and helped propel the capital markets close to historical record levels, is coming to an end. In an exclusive CNBC interview, 57 percent of the economists on Wall Street predicted that the Federal Reserve will start tapering QE in June 2013, which might go on until the fourth quarter of 2014.
That said, a higher 10-year Treasury bond rate has a positive side, and this time it is definitely a reflection of a continuing economic recovery. Four years after the end of the 2007-2009 Great Recession, the U.S. economy is showing multiple signs of a steady recovery that has also been echoed in other parts of the world. China, for example, has already achieved a soft landing and is now on the recovery road. Higher interest rates also give a green line to investors that it is time to move to more risk assets such as stocks.
In economics and finance textbooks, interest rates are used to discount the expected future cash flows of a company. This discounted amount determines the value of a company, which when divided by the number of shares yields the price of stock. Thus, theoretically higher interest rates lead to lower stock prices and returns. Still, history shows that there is a silver lining in increasing interest rates. Interest rates and stock markets can move up in concert if they are propelled by a positive force such as an improvement in the overall economy. In the 1980s, the 10-year Treasury bond rate was more than 10.5 percent, and the stock market achieved a 17 percent return. In the 1990s, this interest rate was 6.5 percent, and the stock market yielded an 18 percent return. Based on these numbers, this Treasury bond rate still has plenty of room to increase hand in hand with the stock market. However, because the economy is still in a liquidity trap, the hand of the stock market should be the pulling hand. That is, the interest rate in the liquidity trap will be reluctant to move up with a speed registered by all radars. Additionally, the threat of sequestration or automatic spending cuts is still looming. If the automatic “sequester” cuts are allowed to take effect, it could take half of a percentage point of economic growth in gross domestic product, which should help keep a lid on interest rates. Nevertheless, there are currently those on Wall Street who believe that the 10-year Treasury rate can go up to 4 percent without hurting the economy.
The stock market can still fetch positive returns in the next few years, and the economy can move up and out of the 2 percent economic growth rate bind. The speed and duration of the improvement is still banded by what is happening in Washington. The political gridlock is a black lining in the U.S. stock market and economy. The government must agree on a plan to reduce the deficit and a budget for the economy. Without this political solution, there will be legitimate concerns about the health of the economy and capital markets.
Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at firstname.lastname@example.org.