Tuesday, October 5, 2010

Yes, Interest Rates Can Move Even Lower


Many investors I speak with, including most of my clients, believe that it is just a matter of time before interest rates move higher.

The problem, as my friend Bob Quinn explains to me, is a behavioral finance phenomena called "framing". Most of us have only known higher interest rates than today's levels in our lives, and so we assume that the prior experiences will be continued into the future.

But it wasn't always so. A generation before ours was much more familiar with lower interest rates, and today's levels would have seemed normal.

For example, in the years after the Federal Reserve was created, one of the tasks assigned to our central bank was to make sure that the interest costs on federal government debt remained low. I found this background on a website named enote.com:

The final step in the modernization of the Federal Reserve System was the Treasury Accord of 1951. Before the accord, the system acted as a buyer of last resort for Treasury debt. If investors demanded interest rates on government bonds above a ceiling (set to 2.5 percent at the time of the accord) the system would step in to buy the residual debt. With government spending hitting new records during the Korean War, this support rule demanded an inflationary monetary policy. Under the terms of the accord, the Federal Reserve System was relieved of the responsibility of keeping interest rates low.

In short, throughout much of the first part of the twentieth century, no one thought that the U.S. government should pay any more than 2.5% for its debt. This rate, by the way, is exactly where the 10 year Treasury note is trading this morning.

Turning to more modern times: as we all know, Japan has been mired in a depressing deflationary economy for the last 20 years. Multiple efforts to restart their economy by government officials have failed but they continue to try. This morning the Bank of Japan cut interest rates back to 0% to try to both weaken the yen as well as provide economic stimulus.

Here's an excerpt from today's New York Times:

It took about four years for the Japanese economy to hit rock bottom after its spectacular asset bubble burst in 1990, and another four for deflation to take hold in 1998. The following year, the Bank of Japan responded by lowering its policy interest rate to zero; by that time, however, the country’s economy was so depressed that even zero interest rates could not bring about recovery.

Critically, it was not until another five years later, in 2003, that the central bank sharply increased its purchases of financial assets to expand the money supply, setting the stage for a gradual recovery. Despite stable economic growth of about 2.5 percent between 2004 and 2007, however, deflation did not disappear completely.

Still, emboldened by a nascent recovery, the Bank of Japan raised its lending rate in July 2006, increasing it to 0.5 percent the following March — a step that some economists and politicians called premature.

Before that debate had fully played out, however, the global economic crisis ravaged Japanese export markets, plunging the country into its worst recession since World War II. In December 2008, the Bank of Japan cut interest rates to 0.1 percent.

Bank of Japan Cuts Rates to as Low as Zero Percent - NYTimes.com

I continue to believe the bigger risk to investors is lower, not higher, interest rates. Savers who keep their assets in a money market fund or short maturity bonds may feel safe today but may find their wait for higher interest rates in the next few years to be quixotic.

It's hard to get rich earning 0.37%, which is where the Treasury 2 year note is trading.