August 31, 2012
Thinking About The Big Finale For Interest Rates
If you had to pick one chart that summarizes the big picture in economics and finance over the past generation or so, what would choose? How about the benchmark 10-year Treasury Note yield? Not only does this history tell us quite a lot about where we’ve been in macro and markets, the 10-year yield’s track record also provides perspective on where we may be going and what we should expect.
A picture’s worth a thousand words, as they say—especially in this case. Here’s the monthly average yields on the 10-year Note from the early 1960s through July 2012. By the way, the 10-year yield as of yesterday: 1.63%, according to the Treasury Department. As you can see in the chart below, that's just about the lowest in modern financial history, and we may go lower still!
It’s clear that interest rates over the past half century or so have had two distinct regimes: rising and falling. The rising regime rolled out from the 1960s to the early 1980s, when the Volcker Fed crushed inflation, at which point rates embarked on a multi-decade fade.
It’s hard to overestimate the significance of this upside-down V history for economics and finance over the decades. Granted, there are multiple factors that come into play for assessing the path of economies and markets. But if we’re ranking the top 10, the V history above would have to be included as a key variable.
Thirty years of falling interest rates isn’t everything, but it’s a lot. For example, consider the great bull market in stocks from the early 1980s through 2000 (a bull market that's had a second life, twice, from roughly 2003-2008, and again for 2009-?). How much of the good times was financed by falling interest rates?
On that point, this is a good time for the uncomfortable observation that the great fall and decline in rates has just about run its course. Nominal yields may fall a bit further, of course, and low rates may persist for some time, depending largely on the economy’s capacity to grow (or not).
But any way you slice it, we’re nearing the end of an interest rate regime that’s been a foundational trend in macro and markets. Exactly when it’ll end is unknown. Many analysts in recent years have warned that the end was near, and they’ve been wrong. At some point this forecast will be right, although one can have a lively debate about whether the end will be next month or a decade from now.
In any case, the big picture on interest rates is worth pondering as you think about design and management of your investment portfolio. What might change if interest rates are no longer falling and flat line for years? Or, what if they start to climb for an extended period? No one really knows, but it’s useful to make some guesses and model the various outcomes.
The end of a 30-year trend of falling rates probably doesn’t mean much for day traders. Even a time horizon of a year or two may not be all that relevant, depending on how this plays out. But at some point, the big denouement in the price of money will affect us all.
Posted by jp at August 31, 2012 10:41 AM
This is interesting, because I finance commercial real estate working for a mid-regional bank and I often wonder about some of the institutional assets being financed for opportunity funds or REITS, what is there residual if interest rates begin to climb and what is their exit strategy? While stabilized CRE assets can provide good returns via in place cash flow today that maybe justify lower risk returns, what happens at the end of the investment horizon if the cash flow profile changes and interest rates are up? What is a reasonable residual or exit cap rate to reflect this risk? I'm caught between two thoughts; I think that investors need to have certainty regarding todays regular cash flow on real estate assets while being concerned with the residual value of the asset at the end of the contractual term of those cash flows and how the two different risk profiles of the cash flow components should impact what is paid to obtain these assets in today's market. Secondly, while I think investors need to be cautious investing in real estate I don't think investors should stop investing because there may be more risk (end of term) in these cash flowing assets today than what is actually perceived in the market. I think investors need to really understand the basic supply/demand fundamentals today more than ever before.
Posted by: James at September 2, 2012 8:05 AM