Interest Rates: A Little Perspective
By Gabe Thornhill, Financial Advisor, MPM Wealth Advisors
It doesn’t seem possible, but interest rates have been falling for almost 35 years. In the fall of 1981, the 10 year U.S. Treasury bond peaked at a yield of roughly 15%. Since that time, it has fallen pretty steadily to the current rate below 2% (Click Figure 1 to enlarge).
For years, I’ve talked with clients and associates about when rates will rise and the impact on our economy when that time comes. If rates moved higher over a short time frame, bond portfolios, real estate and other assets tied to interest rates would almost certainly decline in value. What if instead of rising, rates continue to move lower or stay in the current range for a generation? I don’t pretend to have a crystal ball, but it’s that possibility I want to explore in this blog post.
Figure 1 shows inflation (measured by CPI) and the interest rate on 10 year treasury bonds. Since the high interest rates in the 70’s and early 80’s were associated with high inflation, we’ve all been led to assume that inflation drives interest rates. However, if you look back a little further, you can see two distinct periods of high inflation (early 20’s and Post World War II) when interest rates didn’t seem to react to higher inflation.
Figure 1 uses the Consumer Price Index (CPI) as a measure of inflation and that measure is surely imperfect. However, I constructed an alternative measure that focuses only on commodity prices (Figure 2) and it tells a similar story. While the rise in commodity prices in the 70’s saw a concurrent rise in interest rates, the commodity boom in the 2000’s saw falling interest rates.
My conclusion from these graphs is that inflation and interest rates do not always move in lock step. In fact there have been times of high inflation with low or falling interest rates. Consequently, we could see higher inflation in coming years without an associated rise in interest rates.
International Interest Rates
The global economy continues to become more connected. In the past, the U.S. economy was the engine of growth for much of the world. It dictated the ups and downs for the global economy like no other market. That dominance is changing even as we become more connected. Our economy depends on imports and exports from around the world. When international economies are strong we benefit and vice versa.
Additionally, the capital markets around the world are more connected than in the past. Investors around the world can move money from one region to another with the click of a button. If the Chinese stock market tumbles, the S&P 500 often follows. Why wouldn’t interest rates also be related? Figure 3 shows interest rates in the U.S., Germany and Japan. These are three of the largest bond markets in the world, representing over half of all debt outstanding.
Although I only have data for the last 20 years, the story is pretty consistent. Rates have fallen steadily for the entire period. Additionally, the U.S. rates are now considerably higher than those in Japan and Germany. Figure 4 show US rates lagged 10 years vs. Japanese rates. Based on this comparison, it looks like we are on a similar path.
I’ll reiterate that I’m not predicting our rates will fall to the level of Japan’s, but I wouldn’t rule out the possibility.
Finally, there’s population growth. The US had a surge in population from the Baby Boom and the children of the boomers. That population growth is now slowing and our population is aging. Figure 5 shows population growth since 1950 and interest rates.
We’ve always been worried about too many people. Who can forget the dire predictions of wars for water, oil and food that would result from a world that can’t grow enough food or drill enough oil. The remarkable economic growth of the last 50 years has shown that higher levels of economic achievement and longer life spans lead to lower population growth. Japan and Russia are seeing population declines. Much of Europe is seeing very low growth and the birth rate in developing countries is declining. That slower growth could be another factor keeping U.S. interest rates down in coming year.
Everyone wants simple cause and effect arguments and I’m no different. I’d love to put one graph in this article and say this is the answer. What I do know is that interest rates were much higher in the past, but they could continue to fall going forward. The simple links between inflation and interest rates may not always hold. The interrelated global markets and slowing population growth may combine to keep our interest rates low for years to come. I’ve waited for a 70’s style interest rate boom for 35 years, but it may not come again in my lifetime. The U.S. had sub 5% interest rates for almost 50 years and it could happen again.