Why Interest Rates Should Stay Low(er)

In my morning readings, I came across this post from Bloomberg about Chinese bond issuers facing troubles.  The headline reads:

China Set for Record Defaults, and Downgrades Tip More Pain

Key takeaway:

“rising yields are set to make the refinancing of maturing debt all the tougher for private companies that lack the access to the state-dominated banking system that national behemoths enjoy.”

What does this have to do with anything, you may be asking? Well let me answer that question with one of my own.  What causes yields to rise???

If you said a shrinking demand for the debt that is already out there, you should be a money manager.

But next we’d need to answer this question…Why is demand shrinking?

Because investors don’t believe the bonds will be repaid. Thus the supply of bonds being sold is increasing as current investors try to get out of their holdings but the demand is decreasing as few people want to buy them. Basic supply and demand economics. Higher supply and lower demand do what to prices? Yup, drop them.  Lower prices do what to CURRENT yields? Yup, raise them.

hmmm…sound familiar? In 2007 and 08 that’s exactly what happened here in the good ole US. There was no demand for any bonds other than government. (Warren Buffet being one of the exceptions.  He was on the prowl for buying cheap, cheap debt with his immense cash holdings.  Please learn from him and realize that cash IS an asset class).

Prices drop, yields go up.

With the US currently paying rates significantly higher than other countries, and I mean WAY HIGHER, decreasing demand is not a problem we face.

I am generally not the biggest fan of bonds. Simply because after taxes and inflation you are losing purchasing power.  But the bond market dwarfs the stock market and for your own financial management it’s good to have an idea of what’s going on out there.

Right now the US 10 Year is at 2.84%.  Could it go back to its normal 6% or so.  Sure.  Will it?  One would need to answer what would cause the demand of US debt to drop soooo much that rates would rise that much.

Hard to see that happening anytime soon.

Back in 2009 when I worked at USAA we offered a 10 year fixed annuity that had a guaranteed interest rate of 6%. We also had a 5 year that paid 5.5% and a 2 year that paid 5%.

I remember, like it was yesterday, talking to a guy who was asking about these annuities. I told him “I wouldn’t do the 10 year because interest rates have to go up. Basic economics says it.” I quoted Milton Friedman and others to show how smart I was.

My advice was to do the 2 year annuities and then when they matured, you’d be able to roll those into higher rates because, again, interest rates “have to go up.”

10 Year Annuity At 6% Seems Good Now, eh?

Thankfully, the guy didn’t listen to me and dropped a significant chunk of money into the 10 year fixed annuity, earning 6% each year, guaranteed by USAA, one of the strongest insurance companies in the world.

Getting Killed By The Q’s in 1999-2000

And the days of my market prognostication came to another abrupt end. (The first time was when I was on the trading desk at Charles Schwab in the late 90s and into 2000. I lost a LOT of money on options on the Triple Qs and told myself “never again”.)

Back to the guy and the annuity. Nearly 10 years after our conversation he is still clocking a 6% rate of return GUARANTEED each and every year. Now this annuity will mature this year and he’ll be looking at a much lower renewal rate. But still, 6%, guaranteed for the preceding 10 years is not too shabby in the least.

So what does this have to do with anything? Well, I came across this article in The Hill today, “The Debt Curve From Hell Is Upon Us”.

Interest Rates Starting To Normalize?

The author states:

With interest rates starting to normalize, net interest costs are expected to grow at an average annual rate of 21.7 percent over the next three years and 7 percent a year on average for the subsequent seven years.

But are interest rates actually starting to normalize? A few months ago the 10 year Treasury Bond broke 3% for the first time in a long time. (I did a video on this here.) It seemed to be well on to its more normal 6% average. Yet where is it today? Back at 2.85%.

History of the 10 Year Treasury Bond

The 10 year is the proxy you should use for interest rates. Here is a good chart from the St. Louis Fed for those of you interested in the history of the 10 year Treasury.

Secondly, the author states, “As recently as fiscal year 2016, for example, the federal government spent $240 billion on interest on the publicly-held federal debt. That’s literally $1 billion less than the federal government spent 20 years earlier to carry a debt only one-fourth as large.”

Federal Government Has Increased Debt 400%

Now think about this. In 2016 the Feds spent less in interest than it did 20 years earlier even though it carried 400% MORE in debt. What does that tell you? That the interest the Feds are paying is incredibly low. So, low in fact, we paid the same amount of interest on a huge increase in debt.

Then author goes on to say: “Rising net interest costs will consume roughly half or more of every new dollar of federal revenue in each of the next three years and more than 27 cents of every new dollar of federal revenue over the next 10 years.”

Yet Total Debt Payments Hardly Increased

And this is the crux of my argument. The Federal Government can not afford for an increase in interest rates. We simply do not have the cash flow to pay for a ‘normalize(d)” return to historical rates.

In fact, back in 2009 an economist, I think it actually may have been Senator Phil Gramm, wrote a piece in the Wall St. Journal stating this exact thing. His premise was that if rates “normalize” the debt payments will dwarf everything else in our budget to include the unfunded mandates of Social Security, Medicare and Medicaid.
We, the US, simply can’t afford to allow rates to increase.

Examples of Bad Economic Theory (Philips Curve)

I cut that article out and laminated it because it went against ALL economic theory. High debts leads to high interest rates, we’ve been told. (We’ve also been told that low unemployment leads to high inflation too, ala the infamous Phillips Curve. And, even after decades of this proving false it’s still taught in Macroeconomics class!)

But high rates didn’t happen. Even 10 years later, the interest rates are less than half the average. And as long as the US has countries willing to pay us for our low level of interest the interest rates will probably remain low.

Europe Still Has Lower Rates Than The US

And as I look at the international markets I see rates still below our own, well other than Greece at 3.90%. Germany is at .30%. Switzerland is still at a negative yield, meaning you lend the Swiss money for 10 years you will get back less than what you lent them.

Even Italy, that economic powerhouse, is below the US at 2.67%.

So, if I am an investor what country looks best for me in terms of total return and safety? This should be a rhetorical question.

Where Can I Get a Better Return With Less Risk?

My conclusion is that as long as demand stays high for our debt, and I see no reason to think it will recede anytime soon, what other bond markets look better? And we are already up against the wall with interest payments on our current debt, it’s hard to make an argument that rates are going to shoot up anytime soon.

Could they? Absolutely. In fact, that I am writing this probably tells you to bet on a ginormous rate increase! My crystal ball has shattered many times over.

But if you get an offer for a 6% guarantee for 10 years backed by one of the strongest insurance companies in the world, I certainly would not call you crazy for dropping some money into it. (Those products don’t exist today though, for the record. If someone says they do…RUN!)

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