Miles on Money: Permanently low interest rates?
Friday, June 27, 2014 6:00 AM
During a back-and-forth on investment opportunities earlier this year, a friend of mine declared in frustration that the words “He hated bonds and they killed him” would be etched on his tombstone.
As a manager of billions of dollars of fixed-income securities, our investment professionals have a more constructive relationship than my friend with the bond markets. But we understand how frustrating the interest rate environment has become.
For years, bond market participants – including a growing number of retirees – have been waiting for interest rates to rise. Looking back on prior recessions, it has often seemed that normal interest rate levels were “just around the corner.” But each time rates have begun to rise, they have reversed course.
Just last summer, when the Federal Reserve announced that it would begin tapering its bond buying program, rates on 10-year Treasury bonds spiked from 1.67 percent in April to 3.01 percent by December. The consensus view was that rates would stay above 3 percent in 2014. Instead, they promptly dipped back below 2.5 percent and have hovered around 2.6 percent since.
Still, U.S. rates remain attractive by comparison with those of other nations. As of this writing, interest rates on the 10-year government bonds of Austria, Belgium, Finland, France, Germany and the Netherlands were all below the U.S. Even the bonds of Spain and Italy paid only 0.08 and 0.18 percent more than the U.S.
On June 5, the European Central Bank took the unprecedented step of lowering its overnight rate to minus 0.10 percent. This is the first time that a major central bank has moved overnight rates negative, and given the ECB’s sole mandate of price stability, took some by surprise. For its part, the ECB stressed the need to lower rates to encourage spending and investment.
Trying to make sense of the current situation, a growing number of commentators have begun to suggest that interest rates will remain permanently low. They typically rely on some combination of three factors. One, U.S. rates are already high in relation to other countries. Two, the U.S. and world economies are going to continue to struggle to generate economic growth for the foreseeable future. (Clearly, stock market participants have held a much rosier view.)
Three, the Federal Reserve has no choice but to keep interest rates low to protect the U.S. government’s ability to service the national debt. We will defer an in-depth conversation of this third factor for another time, but with U.S. national debt now in excess of $17.5 trillion (up threefold since 2000) and annual interest payments running about $425 billion, it’s fair to say that higher interest rates could be a burden.
Still, we don’t subscribe to the theory that rates will remain forever low. To be clear, our scenario planning considers the potential for extended ultra-low interest rates – which for most of our clients would be decidedly negative. But permanent low rates are not our expectation. By ratcheting down its monthly bond purchases (lowered to $35 billion this month), and signaling its intention to make the reverse repo program permanent, the Fed is clearly paving the way for higher rates.
That rates on sovereign debt internationally are below that of the U.S., we see as a reflection of higher U.S. growth prospects and a welcome sign that the credit crisis in Europe is healing. And, we find the Congressional Budget Office’s forecast for 10-year Treasury yields to rise to 4.8 percent by 2017 to be reasonable. We might also note that according to the CBO, the U.S. can service its national debt even at these higher interest rates.
We put little stock in trying to outguess future interest rates moves, preferring instead to focus on managing the risks presented by divergent possible outcomes. Still, we cannot help but hear the ring of capitulation in recent forecasts for permanently low interest rates, perhaps signaling higher rates in the offing.
The views expressed are those of the author as of the date of the article, are for informational purposes only, not meant as investment advice, and are subject to change. Miles Capital does not guarantee the accuracy or completeness of any statements contained in this material and is not obligated to provide updates.
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