Tuesday, April 12, 2016

More on Bonds as a Bad Investment ... A Brief History of U.S. Interest Rates

The rate of return on bonds is a combination of the interest received (yield or coupon rate) and the capital gain or loss, if any, aka the difference between the purchase and sale price of the bond.

The interest rate is the amount of cash received in relation to the purchase price. If we buy a bond at 100 and its coupon rate is 2%, the bond returns 2% annually.

If the bond is purchased at par, or its face value at issuance, the purchase price can be stated as 100. If held to maturity, the redemption price is also 100. In that case, the return or capital gain or loss upon redemption is zero.

Today interest rates are at historic lows. In years to come they will be higher. In that case, the chances of selling the bond before its maturity date for more than its purchase price are slim and none (see yesterday's post). Thus, any sale before the bond's maturity date is likely to result in a capital loss, since bond pricing acts in Teeter Totter fashion, meaning when interest rates increase, the value of the outstanding bond decreases --- and vice versa.

Accordingly, the investment rate of return on bonds in the foreseeable future will at best be the coupon or stated rate, and only then if the bond is bought at par and held until its maturity or redemption date.

Accordingly, investments in bonds made by public sector pension funds and by private sector individual 401(k)/IRA investors will likely earn at best annual rates of return of only ~2% to ~3% in the immediate years ahead --- and perhaps for a very long time to come, based on history as well as the facts on the ground today.

So are today's interest rates really unusually and historically low? Although most people would answer yes to that question, the correct answer is no. Let's see why.

Why Very Low Interest Rates May Stick Around fills us in with accurate historical facts and offers the following conclusion --- "In the long arc of history, high interest rates from 1970 to 2007 look like the aberration, not the norm:"

"The Federal Reserve will most likely raise interest rates . . . . To understand what it means — and doesn’t mean — consider a previous year in which interest rates were on the rise.

In 1920, borrowing costs soared to their highest levels since the end of the Civil War. Some people were terrified of what it was doing to the economy. Higher rates “would practically legalize usury,” a real estate trade group warned. A Democratic senator complained that “manufacturers, merchants and businessmen are entitled to stability” after a steep rise in rates. The Federal Reserve was “confronted with conditions more or less abnormal,” acknowledged a governor of the central bank, William P. G. Harding.

The interest rate that caused this anxiety? A mere 5.4 percent on the 10-year United States Treasury note — lower than the rates during the entirety of the 1980s and most of the 1990s....

Investors have often talked about the global economy since the crisis as reflecting a “new normal” of slow growth and low inflation. But, just maybe, we have really returned to the old normal.

Very low rates have often persisted for decades upon decades, pretty much whenever inflation is quiescent, as it is now. The interest rate on a 10-year Treasury note was below 4 percent every year from 1876 to 1919, then again from 1924 to 1958. . . .

The real aberration looks like the 7.3 percent average experienced in the United States from 1970 to 2007.

William P.G. Harding of the Federal Reserve Board, circa 1914, in an era when rates were low, and that was normal.            

“We’re returning to normal, and it’s just taken time for people to realize that,” said Bryan Taylor, chief economist of Global Financial Data, which scours old records to calculate historical financial data, including the figures cited here. “I think interest rates are going to stay low for several decades. . . ."
How much investors demand as compensation for lending their money is shaped in no small part by how much they think that money will be able to buy when they get it back. And the pressures that normally generate inflation seem to have disappeared in recent years.

The Fed and its counterparts overseas at the European Central Bank and Bank of Japan have spent the last few years applying every policy they can think of to get inflation to rise up to their 2 percent target, with limited success. In a world awash in supply of workers, oil and more, financial markets show little sign that investors think that will change anytime soon. Current Treasury bond prices predict annual inflation in the United States of only 1.7 percent a year over the next three decades.

That would imply that we are in an economic era more like the late 19th century, with persistent low inflation or mild deflation, or perhaps like the 1950s, when the economy was growing but inflation was firmly in check.

“If we keep inflation under control, maybe we’ll enter a period like the ’50s,” said Richard Sylla, a financial historian at New York University and co-author of “A History of Interest Rates.” “Those were normal rates, and they were accompanied by a slight amount of inflation, 1 or 2 percent. That worried people then, where now it’s a target to be reached.

Both financial markets and Federal Reserve officials seem to believe some version of this forecast. To understand why, it helps to start with a bit of the math behind the multitrillion-dollar bond market.

A crucial driver of long-term interest rates (which the Fed doesn’t directly control) is what investors think the Fed will do with short-term interest rates (which it does control). If people thought the Fed was going to raise short-term interest rates up to 5 percent soon, no one would lock their money up in a 10-year bond paying only 2.2 percent. . . .

At the onset of the crisis in 2007, the Fed’s official target rate was 5.25 percent. Now the officials’ median forecast for that rate’s longer-term level is a mere 3.5 percent.

In other words, even after they are done with a series of rate increases, Fed officials envision interest rates substantially lower than they were. . . .

Markets, and Fed forecasts, can be wrong, of course. Neither in 2007 predicted the sharp downshift in inflation and rates that was to come in the crisis. And our understanding of what shapes inflation and growth dynamics is quite limited.

Still, starting with Japan in the 1990s and now across the advanced world, the predominant problems of the last several years have revolved around weak demand, plenty of supply, low inflation and resulting very low interest rates. The simple fact that the Fed is poised to raise rates a bit above zero doesn’t change that.

But the lessons of history do offer this guidance: Whether rates will be high or low a few years from now has very little to do with what the Fed does . . . . It has quite a lot to do with what happens to forces deep inside the economy that are poorly understood and extremely hard to forecast. And just because many people are old enough to remember the high inflation and high rates of the 1970s and 1980s doesn’t mean that is the normal to which the economy will inevitably revert."

Summing Up

Will today's low or modestly higher interest rates continue far into the future?

That may very well be what happens. In fact, it's likely.

Economic growth, the strength of the U.S. dollar, globalization, the price of oil and other commodities, government policies and countless other relevant factors will determine what happens to interest rates and inflation over the long haul.

And in that regard, it won't make much difference what the Federal Reserve decides to do or not do from time to time. They'll in large measure be a bystander and not a meaningful player.

That's my take.

Thanks. Bob.

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