I put a great deal of effort in to analyzing long-term historical trends to better understand the cyclical nature of human behaviour and its impact on financial market prices.
Interest rates are no exception. In fact, interest rates are key to the pricing structure of almost every other asset from stocks, gold and currencies to oil, land and wheat.
Currently, we seem to be in a period of lower rates for longer. And while we may think that these rates are ridiculously low, what does history tell us? As Sidney Homer writes in his book the History of Interest Rates: 2000 B.C. to the Present: “A bird’s-eye view of the history of interest rates will unsettle most preconceived ideas of what is a high rate or a low rate or an average rate. Each generation tends to consider normal the range of interest rates with which it grew up; rates much higher suggest a crisis or seem extortionate, while rates much lower seem artificial or inadequate. Almost every generation is eventually shocked by the behaviour of interest rates because, in fact, market rates on interest in modern times have rarely been stable for long. Usually they are rising or falling to unexpected extremes. A student of the history of interest rates will not be surprised by volatility.”
In the past 5,000 years of recorded history, from the Mesopotamian era in 3000 BC to the present, two big-picture overriding factors have influenced extreme levels of interest rates more than any others: confidence and war.
Typically, declining confidence in a country reduces demand for that nation’s debt, while wars, which are very expensive, often increase the supply of bonds. In most cases, both these factors go hand in hand.
The rise and fall of the Roman Empire provides the classic tale of interest rates following the ebb and flow of a nation and its people. Rates declined from Rome’s earliest history (500 BC) until a period of great commercial development (100 BC to AD 100) and then rose significantly until 300 BC.
This was in line with the relentless expansion of the empire externally and the breakdown in Rome’s political, economic and social confidence internally. For a more recent analysis of global interest rate, consider the chart of long-term British bond yields over the past 300 years as further evidence of the interplay between confidence, war and the level of interest rates.
The peaks in 1784 and 1798 coincide with the Napoleonic Wars, while the high rates in 1920 followed the end of the First World War.
The Vietnam War, the Arab oil embargo in the early 1970s plus the Iranian Revolution in 1979 shook investors’ confidence in the international system in the late 1970s, causing inflation and interest rates to skyrocket to previously unseen levels.
By comparison, the relatively low and calm interest-rate environment in the latter half of the 1800s resulted from peace among the major nations of Europe. While these periods span many years, the same themes recur often enough over varying periods to show how war and confidence significantly affect bond yields.
While wars are expensive and can erode the value of a country’s finances, bond prices and yields are also determined by a number of economic confidence factors including…
- Real economic GDP growth;
- Debt supply and investment demand; and
- Credit risk.
In theory, government bond yields should roughly equal nominal GDP growth, which is the opportunity cost of holding a government bond both in terms of investment returns (real GDP) and the time value of money (inflation).
Higher growth or inflation should result in higher interest rates. Increases in the supply of bonds will lead to higher interest rates, while increases in savings will lead to lower interest rates.
Also, a higher perceived creditworthiness and lesser ability to repay can lead to higher interest rates. Investors are concerned about both a credit default as well as an inflationary default.
If the government creates too much money causing inflation and depreciating the currency, it pays back the bonds with cheaper money. All of these factors impact government bonds prices and therefore yields.
Turning back to the present day, we are in a lower rate environment and have been for almost 20 years. The U.S. had similar low rates in the 1950s and U.K. rates hovered around three per cent for nearly a century throughout the 1800s.
While there are many differences between now and then, rates can reach low levels and stay there longer than we thought possible. Taking this one step further, many major countries around the world now have negative bond rates.
The average interest rate for government debt with negative yields throughout Europe and Japan is around negative 0.5 per cent. At the same time, a similar U.S. rate is positive 1.4 per cent, while Canada is plus 1.2 per cent.
Bottom line, never say never in the markets so it is possible we see negative rates in both Canada and the U.S. In fact, Trump recently said “The Federal Reserve should get our interest rates down to ZERO, or less… to do what other countries are already doing.” The U.S. is trying to follow lower rates in Europe and Japan. Could Canada follow the U.S. as well?