What really are interest rates? My response to this question may seem oversimplified to some, but the purpose of this article is to highlight why interest rates seem to go down over time and why they may well continue to do so, despite short term swings.
To the economist, they are a tool of monetary policy. For debtors, it is the additional cost imposed on a loan. For the lender, the amount of the interest imposed reflects the risk of recovery of the loan. To investors, it is the acceptable return on a particular investment.
In all cases, it is the cost of money. This goes up in times of stress and down when things are good. Central bankers use it as a way to affect the money available, banks use it to take advantage of money available and debtors use it to gauge how much they really need the money available.
First some historical perspective. According to some, the 1980’s marked the beginning of globalization, thanks in large part to the thawing of relations between East and West. Inflation peaked at 14.76% in 1980 and since then the percent change in the median consumer price index has drifted downwards. By itself, change in CPI may not look like much in the following graph, but it illustrates how rarely the US suffers inflationary shocks. In fact, it seems as though the US suffers from deflationary shocks, more so than inflationary. Whenever the change in median CPI rises dramatically, it is after a precipitous drop. Every episode is followed by a period in which the range of changes is fairly limited. Even more importantly, from a purely mathematical perspective, percent changes from ever-lower levels in benchmark rates result in ever smaller changes in real values.
The US Federal Reserve uses the Fed Funds Rate to boost or reduce liquidity in the system. Rate hikes occur, though it is abundantly clear that the Federal Reserve requires less interest rates to affect the economy. I believe most readers will agree that, in the absence of hyper-inflation, the US may never have to raise rates again to the levels seen in the 1980’s.
The major debate in financial markets today is caused by the threat of higher interest rates, causing many to predict the end of the 34-year bull market in bonds. Naturally, this seems plausible because of where rates have been in the past, but for that to happen the US needs the percent change in median CPI to rise almost uncontrollably from what we have seen in the last couple of decades, which I believe is highly unlikely, not impossible, but improbable.
Increases in interest rates cause changes throughout the entire yield curve of US Treasury bonds. What is less appreciated is the fact that increases in interest rates are relatively short lived and the long end of the curve has a tendency to end up yielding less than short term rates during these periods, due to curve flattening or inversion. In other words, the Federal Reserve usually overreacts with rate rises, slowing the economy in such fashion that it becomes necessary to lower rates once again.
One big reason why it is difficult to maintain rates at elevated levels is it’s impact on the velocity of money. Think of interest rates as the brakes of a car. By raising the cost of money, the FED effectively slows down the quantity of transactions that occur with every dollar that is printed and on the street.
Logically, to have inflation, you need more money chasing fewer goods. It is understood that, after the dotcom bust and financial crisis, the US has an excess of dollars on the street and the Velocity of M2 Money Stock shows absolutely no signs of waking up.
Instead, much of the money created and later held by corporations has been used to buy back stock, instead of being reinvested in projects to drive organic growth, limiting the multiplier effect. According to research provided by Michael Hartnett of BofAML (thanks @DiMartinoBooth), “For every one job created in the United States in the last decade, $296,000 has been spent on share buybacks.”
Where is the consumer? Simple answer: entrenched and not coming out of the foxhole. Crushed by the financial crisis, the consumer has reduced debt service payments as a percent of disposable personal income to levels not seen in decades.
Those are the reasons why productivity and wages are key, in the eyes of economists and the Fed alike. Unfortunately, the Industrial Production Index is turning over…
…and wages maintain a negative tendency, because technology is being utilized to reduce the amount of workers used.
The US government is attempting to push higher wages on the economy, to which the ex-President and CEO of McDonald’s USA opines: “…a $15 minimum wage would lead to greater automation within the locations of that company and its franchisees.” – Tim Worstall in Forbes on May 26, 2016. I will leave analysis of ObamaCare to others.
This reaction on the part of corporations is indicative of the inability to pass on higher costs to consumers and the economy in general. If they pass on too many costs, sales will fall, and sales aren’t booming. In fact, inventories are growing faster than sales.
Automation is a tool for a reduction of labor costs. Keith McCullough (@KeithMcCullough) of Hedgeye Risk Management loves to beat the table with, increased hiring is the last wave of the economic cycle. The 4-Week Moving Average of Initial Jobless Claims is presently at levels not seen since the mid seventies and the longer this goes on, the closer we are to the next recession.
Now imagine what the economy would look like if the labor participation rate were to continue to increase dramatically, in an environment of rising wages. Company margins will begin to compress and the 4-week moving average of initial claims will soon begin a steady march upwards. A recession will undoubtedly follow.
The US economy has been living with low interest rates for so long that, adding to steady technological advances, some costs of doing business has dropped.
Now, let me drift into the cost of loans. An interest rate on a loan from a bank reflects two things: the cost of money to the bank and the credit quality of the applicant for the loan. Fifty years ago, the local banker knew every family in his town. The expansion of population and business has made it nearly impossible to know your client personally, but due diligence has been make much easier thanks to credit rating and scoring agencies. Granted, mistakes in the collection of information do happen, but the wealth of information found online has reduced the time and cost of due diligence.
Ten years ago, an individual called my office saying that he was Robert Forbes. I asked him if he was related to Steve Forbes. His response? Steve is the “po’ boy of the litter.” All I had to do was do some research online and shortly thereafter I rejected the man’s business. One year ago, a lawyer friend referred a woman to my bank. Initial information was intriguing, she had Russian name and lived in Southeast Asia. After looking her up online, I found out that she was allegedly involved in some fraudulent activity in the Ukraine and New Zealand. Rejected!
These are prime examples of situations with clients that 20 or 30 years ago might have been accepted, but required to pay onerous interest rates, just because they weren’t from Panama and were unknown entities. Today, banks have access to OFAC lists and better communication between international banks. The annual fees for due diligence services are perfectly reasonable, compared to the hiring of private detective services. These are examples of cost savings that permeate the financial industry and the effects and benefits spread out to the larger economy.
The rise of Bitcoin as an electronic currency is a form of rejection of fiat currencies. Nevertheless, it is not bitcoin that is revolutionizing banking, it is Blockchain technology, because it eliminates the use of a middleman in transaction verification and processing. According to a report from Goldman Sachs, the technology can help save capital markets $6 billion a year. More specifically, blockchain can help save up to $900 million in reduced personnel and $700 million from IT systems improvements.
“A key takeaway across these applications is that blockchain is not just about disintermediating the middleman. In some cases, blockchain could disrupt markets and existing participants, while in others, it promises to help drive cost savings by reducing labor-intensive processes and eliminating duplicate effort.”
Now, we have some insight into how some of the costs in the entire financial system will keep dropping. That should help margins, though further growth of banks will remain under pressure thanks to the backlash borne out of the financial crisis. Still, the cost of money should remain relatively low, by all historical comparisons.
There are two important trends that have already begun: bank kiosks, cashless transactions. The entire financial system is becoming more efficient thanks to advances in electronic transaction processing. The days of plastic credit cards are numbered. Don’t get me started on the future impact of Artificial Intelligence (AI). Still, humans do all the programming and we cannot underestimate the importance of programmers, now and in the future.
In summary, financing costs, as represented by the rate imposed by the US central bank, rates used in bank lending and the rate acceptable to debtors, should remain relatively low. It is no longer necessary to levy large rates to affect economic activity. If the effective Federal Funds Rate has been near zero since 2009 and the velocity of money has not recovered, it is easy to posit that small increments in interest rates should impact economic activity more than adequately.
The fact that negative interest rates (NIRP) are being used in other countries also helps put a cap on expected rates of return in the US. Investment is a business that depends on managing risk-reward, comparing expected returns between asset classes and credits. If the EU is fundamentally flawed in its constitution and is engaged in NIRP, most intelligent money managers will prefer to invest in 10-year US Treasury bonds, because they yield 169.6 basis points more that the German Bund. The King of NIRP, Japan, yields 194 basis points less than the UST. Regarding risks to the EU, if Brexit happens, it will mark the beginning of the end of that monetary/economic/not fiscal union.
Admittedly, NIRP is a monetary experiment that may very well end up badly. The commonly recognized cure is phenomenal economic growth, at a time that corporations are doing all they can to cut costs. Banks attempt to take excessive risks when the market is not delivering much. Central bankers attempt to manipulate expectations, when deflation, or disinflation, has creeped into the minds of everyone that gives a damn. In other words, we are in a period of secular stagnation that may well lead to another round of “helicopter money”, which only reinforces my belief that rates and the perception of risk in US government bonds will remain low for the foreseeable future.
My sense is that had Bernanke, et al, not rescued the US economy after the financial crisis, the nature of interest rates might be different. The US lost a great opportunity to cleanse the system, but here we are. Entities were deemed Too Big To Fail and it is reasonable to think that we may have seen more organic growth come from the ashes. Still, evolution is inevitable and though rates may not remain at zero, but neither will they rise to levels of the 1980’s. If they go up much further, they won’t stay there for very long.
Unless of course, the Contemporary Period of history comes to an end and Western economies fall into a Post Modern history of utter chaos, a la Matrix or The Terminator.
“I’ll be back!”