Interest Rates Have Nowhere To Go But Up -- So Why Don't They?

Posted by Alex Frey (@alexhfrey )

Two weeks ago, I wrote about the essential dichotomy facing investors: stocks look quite expensive in absolute terms, but quite reasonable when compared to Treasury bonds. In such an environment, it may be that the key question that you need to answer affirmatively to buy stocks is actually whether interest rates are likely to remain at their current levels for the forseeable future.

Today I want to turn to a more basic question: how and why have interest rates confounded predictions to date by remaining so low for so long?

There has been constant chatter that “interest rates have nowhere to go but up” for more than a decade now. They have not. When a market violates a long-held theory for an extended period of time, one of two things necessarily must be true: either the theory is wrong, or the market is wrong.

In the short-term, it is both feasible and psychologically less damaging to believe the latter. But the longer and longer a period of supposed “market insanity” goes on, the harder it becomes to keep up such an argument. If you claim “the world is going to end in 2010” because of some kind of Mayan prophesy, you don't get to brag from the heavens that you were “right all along” eight millennia later when the planet explodes in a gigantic nuclear war. Being “right about everything except the date” is sometimes the same thing as being “wrong.”

I would argue that we have hit that point with low rates: the people that were arguing that rates had nowhere to go but up for the last fifteen years (and at various times I was among them) can no longer just claim to be “early.” They missed something important, and it's worth trying to figure out what that is, and how it might might explain the era that we are living in.

Of course many at this point will have a two-word answer ready to go: “the Fed.” If it's not market insanity that is keeping interest rates so low, then it must be those loony central bankers and their printing presses.

This argument requires slightly more thought than just blurting “bubble” (after all, it does involve two words instead of one, so long as you count “the” as a word) -- but only slightly.

On a day to day basis, it is certainly true that various mutterings of central-bank officials can move yields significantly one way or the other. But, like the insanity argument, it gets harder to ascribe low rates merely to the Fed the longer they go on, and pretty much impossible to ascribe all of the last twenty years to it. Partly that's because under traditional models, while the Fed can tinker with rates as they see fit in the short-term, they can't alter the long-run supply-demand dynamics that drive the “stable” neutral interest rate. In fact, the only rate that the Fed more or less directly controls is the rate that banks lend each other overnight reserves at the Fed. The Fed can certainly influence longer-term rates by targeting lower short-term rates and stating that it will keep rates lower for a longer time.

But even if the Fed could wave its pen and make the long term bond rate instantaneously go to whatever level it wanted, the larger point is that it still would not have complete control over the bond market. That's because inflation is the ultimate constraint on central bank action. If the Fed sets rates too low for an extended period of time, everyone will want to take out loans and spend, and nobody will want to save any money. Or in economic terms, the demand for money will exceed the supply of savings, and to keep interest rates low, the fed will have to create more money. The result will be inflation. And if it sets rates too high for a long period of time, the result will be too many people trying to save all at once, which will cause deflation and/or a recession (again, the Fed would make up the supply-demand imbalance by taking money out of the system). So even you if you claim that “the Fed” has been the force that has kept rates low for so long, you are faced with answering the nearly equivalent question of why this hasn't created any inflation, as so many thought “QE” was destined to do.

What, other than the Fed, could explain low interest rates? There is a trite three word phrase that we've already encountered a few times that is as good of a place as any to start: supply and demand. As in any market, in the market for loans there there are people that demand money today to do something with it (buy a house or car, or start or expand a new business, for instance). There are other people that are willing to supply money by foregoing some amount of current consumption. The interest-rate is simply the price of money that balances supply and demand, just as the price of oil is the price that balances supply and demand of that quantity.

We can think about the causes of low interest rates, then, in two pieces: 1) Why do more people today want to save money, regardless of the interest rate?), and 2) Why is there less demand for capital today, regardless of the interest rate?

One answer to the first question is that changing global demographics are driving a changing preference between saving money and spending / borrowing it. The preference of an individual for lending vs. borrowing tends to change over the course of his or her lifetime. Those very early in their career usually have spending needs that outstrip their income, so choose to borrow to make up the difference (for instance, to buy a new house or car). Those in their 30s, 40s, and 50s tend to have rising incomes and stable or declining spending needs, so they start to accumulate for retirement. Finally, those that are already retired once again tend to have spending needs that outstrip their income, so they sell assets (“de-accumulate”) to make up the difference.

As baby-boomers near their retirements, they have a strong desire to save money now that will get returned to them in the near future – but the generation of people that would naturally want to take the other end of this trade (“buy now, save later”) is smaller. So the interest rate has to decrease in order to entice enough people to spend and discourage them from saving.

At the macro-level, the biggest event of the past twenty-five years has been the emergence of a billion-plus Chinese, Indian, and southeast Asian workers onto the global economy. This wave of new workers and consumers has multifaceted impacts:

1) Many fast-growing “emerging” economies have practiced an export-driven, “vendor-financed” model in which they sell goods overseas and then lend the proceeds back to the countries that purchased from them. This may partly be a strategy to prevent their own currencies from appreciating in value. The end result is a somewhat “artificial” recycling of savings back into developed-world assets – which drives down the promised returns, or yields, on those assets.

2) Households in emerging-markets have seen a remarkable increase in their incomes. It is human nature for those that have been through hard times (such as the cultural reformation in China or the great depression in the United States) to initially view such an increase as a windfall, or one-time event, and to seek to save it so as to protect themselves from equally hard times in the future. It is the next generation that will (presumably) take on more spendthrift ways.

3) Financial markets in emerging countries have not developed as rapidly as their export-driven real economies. So there is a strong tendency for domestic savings to leak into international financial markets, again driving up the prices / down the yields of assets in the United States, Europe, and Japan, places that have the “liquidity” necessary to absorb a massive flow of new savings.

4) Finally, it has been extensively commented on that the emergence of so large of a labor source has likely at least temporarily depressed wages, which has kept inflation in check and allowed the Fed to hold rates lower than they would have likely been able to before.

There is one more “macro-level” impact that warrants a mention. It has been established (for instance in popular books like Average is Over and The Second Machine Age) that there is a deflationary-character to technological advancements in the internet era. Because of the ubiquity of advertising-supported business models and the near zero marginal cost of serving an additional visitor to a website or user of a mobile app, many of the new services today or either free to consumers, or very inexpensive (think Google searches, Facebook, YouTube, Hulu, etc.). This has at least three effects: it is another powerful deflationary force that has reduced the “inflation premium” that investors will demand in buying bonds, it has allowed the Fed to keep rates low for longer than it otherwise would have been able to, and it has reduced the demand for capital since companies are able to grow with smaller-size investments.

These developments have also served to further concentrate wealth -- which may in turn increase the supply of savings that need to be absorbed by asset markets,  since rich people -- who are unlikely to be able to spend all of their forturnes -- will need to store their money in assets somewhere.

The brain has been hard-wired with an apparently chronic kind of laziness. When faced with difficult questions, it will always look first for the easiest answers – the kinds that, like “bubble” and “the Fed” – require the least amount of additional thought or changes in beliefs. When investing, we should make it do a little more work.


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By Alex Frey