A Brief History of Time

Are interest rates today fundamentally too low based on historical comparison?

It is commonly believed that Treasury rates are lower today than they have been in history. That rates are, in fact, too low, and likely to rise in the future in order to return to "normal" levels. Theories for why rates are low abound. Are extremely low rates a function of massive liquidity? Irresponsible Fed? Foreign buyers? Complacent investors? Baby boomers? Several of these theories suggest that a sudden reversal is possible or even likely.

In the world of financial blogging, where ultra bearishness seems to be in style, and where knowledge of the rates markets is lacking, the belief that rates will soon rise significantly seems to be even more popular. Those that hold this belief often further believe that rising rates will correspond with a substantial decline in the stock market. After all, affordable debt capital supports corporate investment activity, which grows profits, which grows stock prices. Take away low interest rates, and we're looking at a period of weaker profits.

But how low are interest rates really, in historical context? I mean, I hate to break up the gloomy bear's party, but here are some actual facts. Take a look at the following graph:


The blue line is the nominal 10-year Treasury. The dashed blue line is the average from 1962 to 2006. You can see we are well below the average (6.98% average vs. 4.70% today) in nominal terms. But take a look at the red line. There we've adjusted for inflation (by simply subtracting the year-over-year core CPI). There, the current rate of 2.60% is right in line with the long-term average (2.64%).

So what's the point. Well, let's look back at the original question. Are rates fundamentally too low? Looking at the chart above, and adjusting nominal rates for inflation, the answer appears to be no. But is it a worthwhile question to begin with?

The above analysis runs an average from 1962 to 2006 based on annual levels. What if we looked at the average for the last 20 years? The real-rate average would have been 3.04% and rates would have looked "too low" again. Which time period is relevant? If you can reach different conclusions by simply changing the time periods you are using, you really have to question the validity of the analysis.

Many times investors reach conclusions based on little more than a comparison of current levels versus historic levels. Even professionals. Look back at the nominal rate graph above. Most senior investment managers, particularly those operating at larger firms, have probably been in the business between 20 and 30 years. So when those people were starting their careers in the investment business, we were either in the middle of the worst bond bear market in modern history (1976-1984) or we were just coming out of it. From 1984 through 1994 rates were mostly at 7% or above. And the one time rates fell a good bit below that (1993), we were treated with a violent bear market in 1994. Then from 1995 to 1999, if you got bearish every time rates fell, you were rewarded. So really if you started your career in bonds anytime from the 1970's to the mid 1990's, you've been indoctrinated in the idea that when rates fall, they must subsequently rise.

So does this generalized view that rates are fundamentally too low stem from good analysis? Or is this really the equivalent of the theory in child psychology that personality is formed by age six. Maybe the types of markets you go through early in your career color your market views for the rest of your career.

Bottom line is this. Where markets have been doesn't say anything about where they are going. Interest rates are set by supply and demand for money. Supply and demand conditions in 1968 were different than 1983 or 1994 or 2002. So using these data points as a reference, with no other context, is a simplification of what is in fact, a complicated subject.