Since the “Great Recession” of 2008/09 there has been a widely held view that interest rates are too low and that they will eventually rise to prerecession levels. This view is even more prevalent today as Federal Reserve Bank policy makers have joined the chorus of those considering calling for higher rates. While it is virtually impossible to forecast interest rates, as investors and consumers we should be asking ourselves: Is it a given that interest rates will soon rise from present levels?
There are three factors that have the greatest impact on interest rates over longer periods of time: The level and direction of inflation, the level and direction of interest rates in other countries competing with and trading with the United States, and the current policy of the central bank with respect to interest rates.
Historically bonds have provided investors with a return of 1-2 percent in excess of the inflation rate. This return varies with the maturity of the bonds the investor is purchasing (interest rate risk) as well as the credit quality of the bonds (default or credit risk). The longer the maturity of the bond(s) the investor is willing to hold the greater the inflation premium they should expect. Further, if an investor is willing to take on a greater risk of default by the bond issuer a higher rate of return can be expected.
The second factor that has an influence on U.S. interest rates (bond yields) is the level and direction of interest rates in other countries, especially those that compete with the United States for resources, labor, and goods and services. Countries such as Germany, Japan, India and others are closely tied to the United States in consumption and production of goods and services. As a result, investment, inflation and employment are also closely tied.
With inflation in most developed economies near zero, policy makers are as concerned about falling prices (deflation) as they are about rising prices (inflation). The “deflation scenario” is one that central bank policy makers feel carries the greatest threat to the global economy. This is because deflation causes debt burdens to become larger in real terms and hence more difficult to service. This also means slower economic growth and the potential for rising unemployment, factors the central banks are charged with preventing.
One of the headwinds that central bank policy makers are dealing with is the demographics of aging populations. This is due to both increased longevity and lower birth rates and its effects are felt most acutely in developed economies. Many of the promises that governments have made to their citizens (Social Security, healthcare, etc.) are based on the need for young people who are working to pay the bills as they come due. With fewer workers to pay the bills of the older generation(s) increased government debt is a consequence. Given the pressures of aging populations, relatively benign economic growth and near zero inflation in most of the developed economies we should consider the possibility that interest rates will remain near present levels for an extended period of time.
While interest rates could remain “low” for some time it does not mean investors cannot earn a reasonable rate of return, especially after adjusting for inflation. In today’s environment a well-diversified bond portfolio is producing yields in the 3-4 percent range while inflation is averaging near 1 percent. This means that investors are actually better off than they were during the 1970s when inflation was running over 12 percent on an annual basis and 10-Year government bonds were yielding roughly the same.
Sterling Russell is the director of fixed income at Yellowstone Partners, which recently opened a new branch in Boise.