Tuesday, May 15, 2007

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:

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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.


Anonymous said...

Agreed all along the line.


1) Many would say that inflation has been low-balled for a long time. Hence, real rates are lower.

2) The real question, as you imply, is where are rates headed?

Or, put another way, what are the constraints on interest rates right now?

The yen and the yuan are currencies that are heavily manipulated by their respective central banks. The euro on the other hand is floating with reference to the dollar.

Already, the world has been flooded with enough dollars to drive the euro up by 50%.

If interest rates are lowered from their current level, the euro will rise again.

The question is: is this event (the further fall of the dollar with reference to the euro) an event that will help or hurt various constituencies around the world?

In addition, will the yen or yuan ever float, and, if they do, what will be the result?

Accrued Interest said...

I think the yuan and yen will be allowed to vary more over time. Basically because I believe all manipulation schemes eventually come to an end. Badly. Now eventually could be 20 years, but eventually I think China will be forced to accept the market for their currency.

Anonymous said...

Is not the large amount of US funds held by the China's Central Bank the major factor that will determine the future of US interest rates? If China chooses to, because of the US Government being too politically aggressive, hurt the US economy and future world role. China can determine the US Dollar level in relation to other currencies by selling US dollars. US interest rates will have to go up to protect the US dollar. The major reason China is not doing anything now, other than keeping its currency too low in relation to its value, is that they wish to keep selling their goods into the US and accumulate dollars, and eventually have the US in a position where they will have to follow China's directions?

Accrued Interest said...

Think about it. China decides to make the US pay by hurting US consumers? Thereby killing their own economy? By causing their holdings in Treasuries to plummet in value?

not my idea of courage.... more like suicide.