How Low Can They Go?

By John Greenwald

MARC COHEN, A HOMEOWNER IN Woodland Hills, California, has a new annual chore. For the past three years in a row, he has refinanced his family's five- bedroom house. "My wife says, 'You must be kidding -- you're doing it again?' " says Cohen, a Merrill Lynch vice president. "It's a pain to do it, but for three weeks of aggravation, you get years of savings on the interest." For his trouble, Cohen now enjoys a 15-year mortgage fixed at 6 3/ 4%, down from the 11 1/2% adjustable-rate loan he originally took out in 1989. His total monthly savings on the payments: $2,000.

Such bargains reflect the financial environment of the 1990s, a period in which interest rates are the lowest in decades and the stock market is setting record highs. With inflation and economic growth both down to a crawl, the low cost of borrowing has become the prime mover of the tepid U.S. economic recovery and the key to how Americans save and invest.

The most dramatic effect is on Wall Street, where the Dow Jones industrial average hit new highs in back-to-back sessions last week as consumers, with increasing boldness, shifted their cash from low-yielding bank deposits into stocks and bonds. The Dow closed at 3640.63, up 25.15 points for the week. At the same time, buyers stampeded to buy long-term bonds in order to lock in rates before they fall any further. Nor were U.S. investors on a solitary binge: hopes for a fall in European loan rates pushed stock exchanges in London and Paris to new highs last week.

In many ways, the new era is a mirror image of the buoyant 1980s, when inflation and economic growth were higher and debt was desirable. Consumers, businesses and the U.S. government borrowed like mad because they figured the economic boom would keep income and salaries growing faster than the debt. Now that growth has slowed, the mentality has changed completely. The Clinton Administration is increasing taxes to fight the deficit, and consumers and corporations are frantically digging out of debt. "I encourage people to wipe the 1980s from their minds from the point of view of investment strategy, because the hyperinflation and high interest rates are gone," says Allen Sinai, chief economist for Economic Advisors, a consulting firm. Today's investment climate looks more like the 1950s and '60s, Sinai says, when inflation and interest rates were reliably low year after year.

While a more robust recovery would put people back to work faster, the slow but steady tempo has a positive side of its own. Among other things, it gives investors the confidence to put their money in longer-term investments. On Wall Street outspoken bulls insist that the stock market still has plenty of room to grow. Elaine Garzarelli, an investment strategist for Lehman Bros., looks for the Dow to hit 4000 by the end of the year and climb to 4600 in 1994. "My feeling is that any correction would be minor," Garzarelli says. "Interest rates would have to go up to offer an alternative to money going into stocks."

Stock mutual funds, which are growing at a record pace of $10 billion a month, have been the big beneficiaries of the Wall Street stampede. At Fidelity Investments, the largest U.S. manager of mutual funds, executive vice president Neal Litvak said August was producing the heaviest volume of new business all year. The fresh money has been propping up stock prices as fund managers scramble to locate attractive issues to add to their portfolios.

Investors who pull their savings out of banks generally head straight for conservative funds. Among the most popular are balanced funds, which combine blue-chip stocks with high-quality bonds. Asset-managing funds, which diversify their investments among stocks, bonds and money-market instruments, are also on a roll. Hottest of all are tax-free bond funds, which customers have been snapping up in response to the Administration's tax hikes.

While declining interest rates have been a boon to the stock market, they have left some cautious investors -- particularly elderly people who rely on the interest from their savings -- lagging behind. "Obviously, savers are penalized," says Donald Clark, chairman of Household International, a major consumer-finance firm. "If you have all your money in CDs, you're really hurting." In 1990, when rates on savings accounts averaged 7.9%, people who held one-year bank deposits earned $16 billion in interest payments. Today, with rates at less than half that level, those same little-guy savers are earning just $4.9 billion on their money.

Even so, Wall Street is genuinely divided on the subject; some gurus caution investors to stick with their modest interest income rather than shift their savings to riskier securities. Reason: a sudden spurt in interest rates could drive stock and bond prices down. "A lot of investors who are selling their CDs at 3%, and who keep buying bonds with yields above 6%, are not aware that they are risking capital," says Peter Canelo, chief market strategist for NatWest Securities. "People should not be investing in stocks or bonds," he warns. "They should stay in 6- to 30-month CDs."

In fact, the fate of stock and bond portfolios now depends to an extraordinary degree on the prospects for interest rates. While predicting what rates may do is always an iffy proposition, economists generally expect them to remain low for the next 18 months and perhaps even fall a bit more. That's because the slo-mo recovery shows no real signs of pushing up inflation, and interest rates reflect the level of inflation more than anything else.

For all their power over the markets, however, low rates have added little real zest to the American economy, which has been growing less than 2% a year. The effect of the Clinton Administration's tax increases and deficit reduction will probably be a wash. Presidential advisers credit the deficit-cutting plan with fostering a decline of 1 1/2 percentage points in long-term interest rates since November, which they say will provide the equivalent of at least $50 billion a year in fiscal stimulation. While many private analysts dispute the Administration's calculations, Laura Tyson, Clinton's top economist, retorts, "If we had done nothing, we probably would have seen a rise in interest rates that would have choked off the recovery."

Still, consumers worry about the prospect of additional taxes to pay for health-care reform. And they remain too nervous about their jobs to increase their spending much. Gauges of consumer confidence have fallen steadily since April. "In some sense, I've got a greater feeling of security today," says Michael Segal, a Los Angeles real estate investor. "I've refinanced my home three times, and I feel more at ease with the purchases I make. However, there is an unanticipated something out there, a fear of the unknown. There should be even more security than there is, but it just isn't there."

If the economy stays in low gear and inflation remains dormant, further rate drops could keep the bulls running on Wall Street and create another frenzied wave of mortgage refinancing. Before interest rates plunged in recent years, homeowners clung to a rule of thumb that said people should refinance only when rates fell at least two percentage points below the interest on their existing loans. Under that formula, the gains from lower mortgage rates would exceed the closing costs on the refinancing. But today banks and mortgage brokers offer so many refinancing options that canny rate surfers can replace their mortgages at little cost. Since 1991, consumers have refinanced $1 trillion worth of mortgages, or fully one-third of all U.S. home loans.

For the economy as a whole, the chief benefit from low rates has been the chance for consumers and companies to ease the debt burden that the '80s left behind. Economists say that should pave the way for stronger growth by 1995. Weary Americans might be forgiven, however, for thinking the promised land is still a long way off. "Lower interest rates won't do it alone for us or for our dealers," says Allan Gilmour, vice chairman of Ford Motor Co. "Their steam has just about run out. The economy's biggest problem is that it needs an igniter to get the whole thing going." President Clinton tried that with his deficit-spending proposal to boost the economy earlier this year, but his attempt stirred little public enthusiasm and was defeated by Congress. Without any such stimulus, low interest rates are likely to remain the only road to restoring the confidence of consumers and encouraging companies to start hiring again.

CHART: NOT AVAILABLE

CREDIT: TIME Graphic by Steve Hart

[TMFONT 1 d #666666 d {Source: Federal Home Loan Mortgage Corp.; Federal Reserve}]CAPTION: 30-YEAR FIXED-RATE MORTGAGES

30-YEAR U.S. TREASURY BONDS

3-MONTH CDS

DOW JONES INDUSTRIALS

With reporting by Dan Goodgame/Washington, Adrian J.W. Maher/Los Angeles, William McWhirter/Detroit and Frederick Ungeheuer/New York