Last month, I looked at rising commodity prices, money creation and whether inflation may or may not develop. This month, we’ll look at what all that might mean for interest rates.
Interest rates, according to economic theory, are made up of two components: an inflation figure and the real rate of economic growth. These components will get pushed around by numerous economic, business, government and social supply-and-demand influences. As such, interest rates can go through periods of extreme volatility but we have also had periods where rates stay low and stable for many years, even decades. As you can see on the chart of long-term U.K. government bond rates, low rates are really the norm and high rates are actually the anomaly.
But whether interest rate levels are high or low are relative to where and when you are living. As Sidney Homer writes in his book 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.”
If you want to go even further back, over the past 5,000 years of recorded history, from the Mesopotamian era in 3000 BC to the present, two factors have influenced these 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, or other major spending programs like during this COVID era, are very expensive and often increase the supply of bonds. In many cases, both these factors go hand in hand. History has also shown that interest rates reflect the economic and population growth of a country as well as price stability or inflationary policies.
So, what is the current state of the interest rate environment telling us? Basically, there are artificially low or negative government bond rates almost everywhere across the major industrialized countries of Europe, Japan and North America. Government of Canada bond yields are around one per cent or less for the next 10 years with similar rates for U.S. Treasury bonds. Even forward variable commercial lending rates two to three years out in Canada and the U.S. are currently only about one per cent higher than they are today, based on short-term interest rate futures curves. Euro currency government bond rates are still negative all the way from one year to 30 years out across much of Europe. If you could set your own loan rates, wouldn’t you try to keep them as low and as close to zero for as long as possible? While governments can’t control rates forever since eventually market rates will determine the acceptable level, they could still stay down at these levels for a long time.
Interestingly, intra-governmental ownership of U.S. government debt in social security trust funds, government pension plans and Medicare trust funds and other government agencies account for almost 25 per cent of all U.S. treasuries outstanding. Roughly another third is held by the U.S. Federal Reserve bank. In fact, all the net new bonds issued by the U.S. Treasury are purchased by the U.S. Federal Reserve central bank. Another benefit of the Federal Reserve owning U.S. treasuries is that the Federal Reserve uses excess bank reserves and its own balance sheet to buy Treasury debt, then gives the interest it receives right back to the U.S. Treasury. So this part of the federal debt is effectively at zero interest. Combined, about half of all U.S. Treasury debt is held by government agencies, trust funds and associated or affiliated organizations.
It’s kind of like taking out a loan from your spouse; you can determine your own price and for all intents and purposes you never even have to pay it back since you owe a lot of it to yourselves. If and when the U.S. government, and all national governments for that matter, has to pay back its debt, it can just pay it back with a cheaper inflated currency. Sounds like a great game but you have to be the government of a leading rich country with your own central bank to play.
Bottom line, as the saying goes, when it comes to the markets, it doesn’t matter until it matters and then it really matters.
Eventually rates will go up but for now, major governments and central banks have interest rates pinned near zero. As we’ve seen in the past, they can stay low and go sideways for years to come. So maybe we won’t see interest rates move up any time soon. We’ve had 40 years of falling rates and over a decade of ultra-low rates around the world. Governments don’t really want to pay higher rates on their borrowing. As always though in business, expect the unexpected since higher rates could be as surprising and painful an event as they come. Regardless if rates go up or just stay the same, borrowing costs are so low it makes sense to review your borrowings and secure these low rates for the long term.