The Future of Interest Rates

Last week, I focused on my thoughts on the prospects for interest rates. As I added up all the pluses and minuses, it turned out that my view of rates suggests that interest rates are likely to head lower. In today’s blog, I spend a bit more energy discussing the possibility that at some point in time, there are a couple of scenarios which can take interest rates dramatically higher, and for this reason, I am taking the time today, to caution against blindly investing in long term bonds, because the high rate scenario could be catastrophic, so as not to warrant assuming that sort of risk.


* Interest Rates – last Thursday, I did a piece on interest rates, in which I concluded that there were more bullish factors for rates to fall further, than there is for rates to rise. While I do believe this scenario will come to pass, there is one scenario which has rates rising, in such a way as to destroy the returns and value of ones portfolio. This is the scenario in which inflation starts kicking back in, and the Fed does nothing to contain long term interest rates. In fact, it could be argued, that such a scenario could cause the Fed to tighten credit. I am going to dwell on the bearish bond market scenario for the purposes of curbing any bond marketenthusiasm which that last Thursday’s blog might have generated. In short, the persistence of a bond market rally is going to have to rely on deflation or the active participation of the Fed, via its money printing operations known as QE. 


What bothers me most about the bond market is the massive amounts of debt which the US has accumulated, is around $13.4 trillion, which is almost the size of this country’s GDP at $14.5 trillion. Of the $13.4 trillion deficit, about $3+ trillion is owed to the social security and medicare/medicaid trust funds, so really, the government still owes about $10 trillion to the outside world. With an average marginal cost of money around 1%, this does not seem to be a problem, does it? I mean, if all the debt were to roll over today, at a cost of 1%, then that would cost a modest $100 billion a year, which is less than the current cost of debt service. So long as investors keep buying our debt, then all is well. 


This debt situation in Japan is worse than in the US, whose debt is twice its GDP, yet Japan seems to have no problem rolling over its debt, and their interest rates are the lowest in the world. How long can this situation in Japan persist, and what does it say about the prospects of our own government’s ability to roll over its debt?


The short answer is that we are in times which do not make intuitive sense. It is like the Seinfeld episode in which George does the opposite of what his instincts suggest, and with great success:


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The current configuration of interest rates does suggest that we are in a bizarre environment, which does not seem to follow conventional rules. Bond vigilantes have been screaming about the crowding out effects of the government in the credit markets for the last 15 years in Japan, and for the last 1-2 years in the US. In fact, manyhedge funds have placed rising interest rate bets in Japan and the US over these time periods, with lots of red ink to show for the experience.


So how can we learn from Japan, and how much of their experience is similar to the US’s? Driving the Japanese experience is the persistence of a multi-decade trade surplus. In fact, Japan used to be the dominant export nation in the world, and they still are dominant, except for the fact that China has over-taken their #1 place. As with China, Japan accumulated many foreign currency reserves, and predominately, of the US. To the extent that Japan converts some of these reserves back into their own currency, then that puts pressure on their currency to rise, and of course, with a surplus of money in the local financial system, that has helped drive interest rates lower. In contrast to China, Japan is a mature economy, and their citizens are used to earning high wages. On the margin, there are fewer places for the Japanese to invest their money, except in safe assets, such as government debt. China, in contrast is growing at a rate of 5-10% a year, and there are huge, undeveloped markets for their economy to expand into. Additionally, there is a huge pool of low wage laborers to support an export driven economy. As such, it would seem to me that there are plenty of investment opportunities within China, versus Japan where the marginal investment is going to go into a passive investment, like government bonds.


The US is completely different from Japan, as we are a trade deficit nation. The world is happy accumulating the dollars which we send them, because the dollar is considered to be the reserve currency of the world. So far, so good. Over the last 25 years, the US has run a cumulative trade deficit approaching $8 trillion, and the world has gladly accepted our IOUs. The real question about the viability of the US as a debtor nation will rely on the willingness of our creditors to let us continue to run trillion dollar deficits as far as the eye can see. What is going to tip the scales against the US, and push the rate on government debt to higher levels? It is supposed to be a function of the supply of credit to the US, as investors dictate, and the amount of credit required to balance the US’s budget. As I have been postulating the last few weeks, the other player in the government debt markets is the Fed, which has the ability to buy all the debt there is. This is exactly what the Fed did in the late 1940s, keeping interest rates below 2.5%, despite a 2 years of annual CPI increases of 12.5%.


In the recent history of the Fed, we are not used to the Fed controlling the interest rate on long dated debt. Instead, the Fed controlled short term interest rate, and let market forces dictate long term interest rates. And that is pretty much how the Fed has operated since 1951. Although with the Fed’s recent incursion into the money printing business (via QE), the Fed has re-emerged as a participant on the long and intermediate end of the treasury curve.


On the side for rising interest rates, we have the potential of commodity induced inflation, which should eventually come into play. Counteracting that has been the moribund real estate market, and with 40% of the CPI coming from housing, this has been a major factor holding back domestic CPI in the US. The inflation concerns are tomorrow’s concerns, although I must admit that the seeds for commodity induced inflation have been planted and are growing in the developing countries. 


Also on the side for higher rates, there are concerns about the fiscal health of the US, and the secondary concerns of how the US would be able to service its debt if rates start to rise. The concerns which this line of thinking engenders, is to suggest that you should not buy US debt, at any rate, and unfortunately, this logic also suggests that the downside for being wrong could be quite catastrophic. Sadly, this possibility also has me very cautious about investing in longer term US debt, and for that matter, any debt securities more than a few years in maturity.


If you are an institutional investor, and your mandate is to buy long term debt, then you are also in a position to manage your portfolio should rates start to move to much higher levels. To that end, I would watch the 3.50 level on the 10 year. If rates go above that level, then I would start to raise the caution flag, and above 4% on the 10 year, would represent a break of the current trading range. With rates ensconced at 2.64, this is not an immediate concern, but again, nor is a US debt default an immediate concern either. But these are concerns which I cannot take out of my thinking.


If you are investing your savings, or making decisions on bond funds, and are not so apt to pay day to day attention to your investments, I would suggest that you forgo some income, and focus on short duration bond funds, or direct investments, with an average life of 4 years or less. 


While it seems remote, if for some reason the Fed decides they need to fight inflation, despite what the economy is doing, then all bets are off as it pertains to keeping interest rates low. This is not my main view, but the consequences are so dramatic if this scenario plays itself out, that I would only recommend long term bonds to professional asset managers who are on the job, paying attention for the first signs of such an outcome.