Storytelling In The News: #128

Competing stories of the impact of higher interest rates

April 22, 2004

Probably the top story among financial analysts is a future story - figuring out the story of what the financial markets will with likely higher interest rates. Thus Greenspan told a congressional committee this week that rates "must rise at some point to prevent pressures on price inflation from eventually emerging." David Wessels in the Wall Street Journal says that about the only thing he hasn't done is hold up a poster with a big arrow pointing up. So interest rates are going up, but what are the consequences? How else to make sense of it, except through telling a story?

A story from the past: the tale of 1994: Wessels

Wessels tries to understand the future by telling a story from the past. When the Federal Reserve ended a long period of ultra-low interest rates in 1994, the U.S. economy took it well and performed impressively for the rest of the decade. But the rate increases set off a bond-market tidal wave that helped sink the Wall Street firm of Kidder Peabody & Co., California's Orange County and the Mexican economy. Wasn't anyone paying attention?

By the time the Fed raised rates in February 1994 from its low of 3%, officials thought they had prepared markets adequately. They hadn't. "We had a far greater impact than we anticipated," Mr. Greenspan admitted to colleagues on Feb. 28, 1994, Fed transcripts record. "Markets ... clearly have been shocked."

By May, the Fed had moved its short-term rate by 1.25 percentage points. But the bond market, where investors set the longer-term rates that influence mortgage and business borrowing, had pushed up the yield on 10-year Treasury notes even more -- from 5.7% to nearly 7.5%. By November, these rates peaked at above 8%, a sign that investors anticipated more inflation, and more significant Fed rate increases, than Fed officials were expecting. The turmoil whacked businesses, governments and individual investors, who weren't prepared for such swings, including Kidder, Orange County and Mexico.

It wasn't all the Fed's doing. Trade tensions between the U.S. and Japan (then seen as the major Asian economic competitor to the U.S.) and the German central bank's reluctance to cut interest rates (some things don't change) roiled markets. The dollar sank even as the Fed raised rates, confounding experts and exacerbating inflation jitters. The Fed kept raising rates until the federal-funds rate reached 6% in February 1995.

It's sobering to think how many people were wrong at the time, no matter how clear it looks in retrospect.

A story from the present: Zuckerman

Gregory Zuckerman in the Wall Street Journal on the other hand tries to reason things through with a story about what we know of the way an economy functions. He suggests questioning the conventional future story as to what happens when interest rates rise: dump financial and economically sensitive companies, buy defensive stocks and prepare for a bumpy stock-market ride.

This is, he says, because rising rates in and of themselves aren't good for the economy -- or stocks. As rates rise, companies and consumers are forced to pay more to borrow money, fewer mortgage refinancings take place, and yields on bonds become more competitive with returns on stocks. Financial companies, which profit by borrowing money at short-term rates from savers or each other and by lending it at higher rates, can be hurt as it becomes more expensive for them to borrow funds. Rising rates also reduce the value of future cash flows and earnings of stocks such as technology and telecom providers, and can drag down overall price/earnings multiples.

Despite this, Zuckerman however outlines a story suggesting that today many financial and cyclical stocks look attractive, while defensive stocks such as utilities are set for a fall, and the overall market will hold up just fine. "Everybody's worried about interest rates, but the real driver of the stock market is the economy," says Ron Papanek, strategist at RiskMetrics Group, a risk-analysis firm. "The only reason rates are going up is because the economy is heating up, and the stronger demand for products is at least as important as rising rates."

The danger for financial stocks, according to Zuckerman's story, is that many Wall Street firms have been betting big bucks by trading stocks and bonds in the past two years and by underwriting bond deals. When rates rise, such businesses can suffer. And those focused on mortgage lending will suffer as rates shoot higher.

Meanwhile, Zuckerman's story continues to the effect that tech stocks and cyclical stocks should do well as companies boost spending on capital equipment. Goldman's Ms. Cohen says. "Economically sensitive stocks that have been hard hit are starting to look interesting." She cites Intel Corp., which has seen its shares drop to $26.65 from almost $35 in the past four months.

So what areas should investors avoid? According to Zuckerman, utility stocks and real-estate investment trusts. These stocks still have higher dividends than most others, and these dividends become less attractive as rates rise and investors shift to bonds with higher yields.

Bottom line

What to make of this competing storytelling? No one really knows what's going to happen to the economy when interest rates rise, no matter how confidently Wessels or Zuckerman or the other analysts pontificate. All they can do is tell competing stories. If they convince readers, huge flows of money go along with their tales.

Read David Wessel The Wall Street Journal

Read Gregory Zuckerman in The Wall Street Journal

Learn more about leadership and business storytelling

Read The Leader's Guide to Storytelling.