by Archie M. Richards, Jr., CFP^®
October 14, 2002

In the long term, labor's rising productivity will diminish inflation and bring interest rates down to new lows. But in the near term, I expect interest rates to go up. (At this writing, ten-year Treasuries yield 3.63 percent.)

Rates are currently being pushed down by two self-perpetuating cycles. Both will reverse. The first pertains to mortgage loans:

Let's say you buy a house. Your bank provides a $100,000 mortgage loan with an interest rate of 7 percent. The bank obtains the money from a mortgage bank, such as Fannie Mae. The mortgage bank pools your loan with other similar loans and creates bonds - IOUs - which are sold to investors. The bank is lending to you and borrowing the money from investors.

One of your neighbors has money she doesn't need to spend right now. She buys some of the bonds. Indirectly, her money is being lent partly to you.

Okay, you start making monthly payments. Your bank retains a small portion of each payment and passes the rest to the mortgage bank. The bank accumulates the payments from all of the loans that have been pooled into the mortgage bond and every six months makes interest payments to the bond holders, including your neighbor.

Interest rates fall. You obtain a new mortgage with interest of only 5.5 percent and use the proceeds to pay off the old mortgage.

The mortgage bank gets its money back prematurely on your 7 percent mortgage. Many other refinancings are also occurring. The bank receives money back on those, too.

With all these funds, the mortgage bank pays off a portion of the bonds. But there's a lag. With so much refinancing going on, mortgages are being paid off faster than the mortgage banks can reduce their debts to bond holders.

The mortgage banks are left with risk they don't want. To hedge the risk, they buy Treasury bonds. Some mortgage banks, such as Fannie Mae, don't buy Treasuries directly. They buy other kinds of hedges (called "derivatives"), but the people who accept the risk buy Treasuries themselves as the ultimate hedge.

Over time, homeowners have refinanced carloads of mortgages. As hedges, the mortgage banks have therefore bought carloads of Treasury bonds, driving their prices up. Bond prices and interest rates move opposite to one another. Interest rates have therefore come down.

A self-perpetuating cycle results. Falling interest rates induce homeowners to refinance their mortgages. The mortgage banks hedge the risk by buying Treasuries. This drives interest rates down further, which induces homeowners to refinance all the more. On goes the cycle.

But not forever. Self-perpetuating cycles eventually reverse. No one can draw the string of a bow and arrow indefinitely.

Let's say the economy picks up. Interest rates rise a little. Homeowners stop refinancing. The risk to the banks is reduced. With less need to own Treasuries, they sell some of them. The Treasury prices fall, and interest rates rise. The pressure that forced interest rates down unwind, and the rates move up.

The second self-perpetuating cycle pertains to the stock market. No doubt you've noticed that the market has fallen a little. Investors are so gloomy that they're selling everything they can lay their hands on - stocks, corporate bonds, even real estate.

Wanting to put their money where it's safe, they've been reaching for Treasury securities as a half-drowned man would for a raft. The selling of stocks and corporate bonds is overdone. So is the desperation buying of Treasuries.

This cycle will also unravel. Stock prices will rise. Investors will see a glimmer of light. Wanting to return to stocks, they'll sell their Treasuries. As the Treasury prices fall, the interest rates will rise.

Two self-perpetuating cycles are driving interest rates down. Both will reverse. In the near term, the reversals will drive interest rates up. But over the long run, the trend that began over twenty years ago - falling rates - will once again take hold.