Interest Rates are Very, Very Low

| September 3, 2019 | 0 Comments

Over the past few weeks, stock market volatility has risen and the yield on the 10-year Treasury Note has plummeted to the lowest levels since 2016. Roughly one quarter of all bonds outstanding trade at negative yields, mostly outside the U.S. With long-term interest rates lower than short-term rates in the U.S., let’s review some of the implications.

How do bonds work?

Bonds are basically securitized loans. When you buy a government bond, you are actually lending the government money. Like most loans, bonds provide typically offer interest payments (or coupons). For example, a bond with a 2.5 percent coupon would pay you $25 per $1,000 every year until the bond matures (and you get your principal back). Another key point to understand is that the bond’s coupon and yield are not the same thing. Yield is the interest you receive divided by the price you pay for the bond.

When a bond is issued, the market will decide what it’s really worth. For example, in a world where the interest rate on a new 10-year government bond is 1.6 percent, a bond with a coupon of 2.5 percent would sell for a bit of a premium. This illustrates a fundamental characteristic of bonds: prices and yields move in the opposite direction. When prices go down, the yield on a bond goes up, and vice-versa.

What factors affect market interest rates?

Over the long run, the most significant factor affecting interest rates is inflation. This is because a bond-holder’s (lender’s) greatest risk is that the money they lend today won’t buy as much as when they get it back in the future. Other factors play a role as well. For example, investors may sell stocks and buy bonds when they’re worried about the stock market, which temporarily alters the prices and yields of the bond market. Competition for loans would drive up interest rates, and low rates suggest there’s little demand to borrow money.

Why are some yields negative?

A negative interest rate (or yield) means that lenders are paying borrowers to take their loans. Lenders who think that asset prices will be lower in the future might be willing to lend at negative interest rates since their money will buy more in the future than it would today. This suggests these lenders expect falling prices, or deflation. We saw this during the market turbulence of 2008 when getting 99 cents on the dollar on Treasury bills was a safer bet than putting money into stocks.

Falling prices for assets (or goods) can be very corrosive for economic activity. That’s because when people start expecting prices to drop, they stop buying goods and services (or houses), expecting them to be cheaper in the future. This can quickly become a vicious cycle (think 1930).

There are several factors that can cause deflation. Changing demographics is one prime suspect, as aging populations in Europe, China, Japan and the U.S. reduce their spending to make their savings last.

Another possible factor is that the economy may not be running at its full capacity. For example, in America factories are currently running at about 80 percent of capacity. When this happens, businesses in aggregate don’t feel a need to invest in new equipment because they’re not using what they already have. This output gap (the difference between what the economy could produce and what it is producing) is part of the reason interest rates are so low. In this environment, it’s unlikely that trickle-down economic policies (like tax cuts for businesses and business owners) will result in additional economic activity because these are designed to stimulate investment in capacity, which isn’t needed.

Global trade is slowing meaningfully as a result of the Trump Administration’s trade policies. This means there’s less demand for exported or imported products, so the economy writ large is also expected to slow as businesses produce less and consumers buy less (because tariffs make imported goods more expensive. In aggregate, less activity means fewer people working and less need for capital, keeping interest rates low for some time to come, even as the cost of some goods rises.

That’s why interest rates are low: investors are preparing for the possibility of a recession.

This column is prepared by Rick Brooks, CFA®, CFP®. Rick is Director/Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in financial planning and investment management for people preparing for retirement. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.

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