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An excerpt from Doug Henwood's Wall Street (Verso, May/June 1997) on the relations among interest rates, speculation, and reality.
If there is a mother of all markets it is the one for credit. Changes in the terms on which some people let other people use their money move both the financial market and the real economy. When credit is easily gotten, and when interest rates are low and/or falling, the financial markets typically sizzle; when credit is scarce, and rates are high and/or rising, financial markets do badly.
Why is this? Several reasons, the simple ones first. The focus is on stocks, which are often the focus of speculators' most ardent attentions, but it can be applied with only slight modifications to other assets, like real estate, art, and baseball cards.
Cost of playing with other people's money. Speculators - and the word here is used in a morally neutral sense to mean anyone who buys a financial asset in the hope of selling it at a higher price in the near or distant future - typically operate on borrowed money. Any increase in the cost of their funds increases the costs of their doing business, with obvious effects on their enthusiasm and buying power. Someone who borrows money at 5% needs to make well over 5% to justify the great risks of holding stocks or futures - say, just for the sake of argument, 10% or more. Should rates rise to 7%, the margin of safety at a hoped-for 10% return would be reduced, meaning that a return of 12% would be required. And returns of 12% are much rarer than 10%, rare as those are. Consequently, speculative enthusiasm dampens, and prices sag.
Effects on sentiment. When interest rates rise or fall a nontrivial amount, it's usually with the consent or even the intention of the central bank. When central banks lower rates, they're trying to stimulate the real and financial economies; when they raise rates, they're trying to slow them down. Sane speculators never bet against central banks, the center of the entire financial universe: they create money, regulate credit, and often decide whether troubled private banks will live or die. While not almighty, central banks often get what they want, so they affect speculators' sense of the future very powerfully. (Major central banks, that is; the Fed and the Bundesbank are mighty, but the Bank of Mexico is weak and the Bank of Zaïre little more than a joke.) Since financial asset prices are built largely of expectations about the future, stimuli or depressants to those expectations bear very directly on their prices. Optimism boosts prices, and pessimism depresses them.
Relative attractiveness of alternative investments. When interest rates are low or falling, people despair of the earnings on their Treasury bills, bank deposits, or money market funds; they search for juicier profits, and plunge into stocks or long-term bonds, which typically pay higher interest rates