Why aren’t interest rates going up? There are 3 possible reasons
The latest reading on inflation in the United States checked in at 5.3% over the past 12 months, its highest level in 13 years. In fact, inflation hasn’t been more than 3% since 2011.
GDP growth in the second quarter came in at an annualized rate of 6.5%. The Federal Reserve is now projecting 7% economic growth for the whole of 2021, the highest economic growth since the mid-1980s.
Granted, these numbers are coming off a low base from the pandemic slowdown. We should expect outliers in economic data to the upside following outliers to the downside. But with all of the government spending, rising home prices, rising wages, supply shortages, retail spending boom and higher inflation, you would assume this is the perfect environment for interest rates to rise.
And rates did rise a bit, but only for a time. They are now once again falling and show a clear divergence from the latest inflation numbers:
In August the 10 year Treasury yield briefly hit 1.13%.
So what gives? Why are bond investors still accepting paltry bond yields in the face of rising inflation and economic growth? As with most market moves, there is never one overarching reason. There is a lot that goes into the movement of interest rates.
Baby boomers control the bulk of financial assets in this country, with close to $70 trillion in wealth. It’s estimated ten thousand boomers will be retiring every single day through the end of the decade.
When you are approaching or in retirement age, you don’t have as much time or human capital to wait out bear markets. And retirement means your portfolio goes from the accumulation phase to withdrawal mode. For most investors, this means de-risking at least a portion of their portfolio by decreasing their allocation to stocks and increasing their allocation to bonds.
This is why trillions of dollars have continued to flow into fixed-income funds over the past decade despite generationally low yields. If the demand for bonds remains high, that can trump macroeconomic factors.
The Federal Reserve
Demand for bonds extends beyond the investor class as well. The Federal Reserve has taken a much bigger role as a buyer of government bonds in recent years. In 2020, the Fed and the government accounted for nearly 60% of U.S. government bond purchases.
Much of this buying was due to the pandemic but you can see the Fed and government now owns more than one-quarter of U.S. government debt:
When you add up all of the U.S. investors between pensions, insurance companies, individuals and funds that remains the largest holders of government bonds at more than 40%. This is a good reminder that every liability for one party is an asset for another.
What will be interesting in the years ahead is seeing if the Fed will be able to pull out of the debt markets in a big way. With so much debt in this country, it’s hard to see government officials allowing interest rates to go much higher before the interest expense becomes too burdensome.
It’s possible the central bank will be forced to continue playing a large role as a holder of government debt to keep borrowing costs under control.
A repricing of risk-free rates
There could be other big picture reasons (beyond investor demand and central banks) why interest rates aren’t rising as many expected.
The United States has the largest, most mature, most diverse economy and financial markets on the planet by a wide margin. We also have the world’s reserve currency.
Economic historian Richard Sylla once wrote, “the free market long-term rates of interest for any industrial nation, properly charted, provide a sort of fever chart of the economic and political health of that nation.”
This “fever chart” shows up in many of history’s great civilizations. It shows interest rates are higher when economies are unstable and fall over time as countries mature. As countries become wealthier, their borrowing costs typically fall over time.
It’s also possible investors aren’t supposed to earn high rates of return on risk-free government bonds. It’s possible the days of 5% government bond yields in the United States are behind us from a combination of a more mature economy, technological innovation, higher levels of wealth, lower barriers to entry to investors and the increased intervention from central banks in the financial markets.
Why should investors be compensated with a high rate of interest for holding an asset that is guaranteed to pay you back?
Nothing lasts always and forever in the financial markets so it would be naive to assume these forces will be able to counteract the macroeconomy forever if things continue to improve. If this year proves anything it’s that the path of interest rates is extremely difficult to predict.
But it might be time for investors to prepare for a world in which interest rates stay relatively low for a very long time.
Certain of the securities mentioned in the article may be currently held, have been held, or may be held in the future in the personal portfolio or a portfolio managed by Ritholtz Wealth Management
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