Why are Interest Rates Still So Low?
The Facts!
The objective of this short report is to outline a basic thesis that the global economy has reached a stagflationary tipping point where:
- The low for interest rates is in for the multi-decade cycle and the move to higher interest rates has begun.
- Interest rates need to go higher to help rebalance the shortages in the real economy.
- Stock prices are facing increased choppiness as higher interest rates, higher raw material costs, and supply chain bottlenecks are having an impact bottom lines.
- Real estate prices are facing significant headwinds via higher interest rates, stiffer lending requirements, and the fallout from the Chinese real estate crackdown.
Let’s examine the evidence.
The employment report in Canada was excellent last month.
The chart below shows Canada has regained all of the jobs lost in the pandemic now!
The next chart shows the US has not gained back all the jobs from prior to the economic shutdowns during Covid-19 protocols, but is getting close.
Stock markets have made all-time highs in both Canada and the US.
Real estate prices have gone parabolic.
What an astounding recovery after one of the most intense economic shocks the world has ever seen.
Which begs the question: So why are interest rates still at such low levels?
The chart above is the 5-year Canadian bond yield showing 1.41%. This is still very low, but up sharply since the Bank of Canada announced an end to Quantitative Easing.
The obvious answer nobody wants to hear is that there is just way too much debt outstanding to ever raise interest rates. At least this is the narrative we are sold by financial pundits.
If only it were totally up to the central banks and politicians as to how interest rates would behave. Then interest rates would likely never rise again, more on this point in the next section.
Thankfully, investors (bondholders) have something to say about the level of interest rates.
They can vote with their feet, selling their bond holdings, if they believe the nominal bond yield is too far below the prevailing interest rate.
It appears bond investors are starting to re-think their levels of exposure.
So let’s consider two questions:
- What are the actual rates of inflation in Canada and the US right now?
My guess is that it is between 4.5% and 6%, but this is just an estimate.
- What is the appropriate interest rate on short term bonds? And now long term bonds given that rate of inflation?
The central banks are hanging their thesis on the idea that inflation is “transitory,” but that idea is starting to run a little thin.
Historically, bond investors have demanded a rate of return ABOVE the rate of inflation to buy (or continue holding) bonds, but as central banks became buyers of last resort, being completely price insensitive, bond yields began to trade below the inflation rate.
As the meme went on in time, bonds actually traded with negative yields.
Inflation is now running at levels not seen in decades.
Investors continue to watch yields rise in response to these high inflation levels.
So far, the bond market response has been muted.
Why are Interest Rates Still So Low?
The Narrative!
The “Everything Bubble” inhales its vitality via freshly minted money that liquefies the financial system. Interest rates are suppressed and the market participants believe this will never change – The Narrative
This belief gives investors courage to both, hang on for the long term, and to take outsized, leveraged risks with their money.
The narrative above is deeply ingrained in asset markets. Investors must balance “the facts” with “the narrative”.
Let’s consider some potential outcomes.
Case 1: The Narrative holds
In this scenario, asset prices continue higher as the central banks continue to liquefy the financial system and suppress interest rates. Inflation intensifies and investor scramble to hold anything but cash.
In the Adam Fergusson book, When Money Dies, there are numerous historical anecdotal accounts of life in Austria from 1918-1922.
The common theme from that time period is that people were trapped in their home currency, which was being devalued, and bought ANYTHING to try and hedge the loss of purchasing power.
Our 2021 financial market situation is similar, yet far less extreme.
If the narrative holds, I expect investors to continue with similar behaviour that they have been exhibiting since the March 2020 bottom in financial markets: Shun safety, borrow money, buy assets.
It is fine to adopt this philosophy as long as there is a “stop loss” in mind to take a different investment posture.
Case 2: The Facts take hold
In this situation, interest rates begin to reflect the higher inflation rates and asset prices stagnate as leverage is reduced. I would also expect P/E multiples trend lower as well.
In this scenario, my expectation would be for stock prices to perform poorly, but not horribly.
For example, if I use the end of year 2023 timeframe, and assume a 3.5% 10 year US Treasury rate at that time, my target for the S&P500 would be around 4000 (presently 4450).
Investor confidence would be a key to consider here.
If investors stay confident, I believe my targets would hold, but if investors grow fearful, a larger downside would likely present itself.
This is why I use stop loss levels on my portfolios.
Yes, it causes some extra buys and sells, which reduce rate of return profiles if the BULL market keeps on racing forward. But, like any insurance policy, it pays off if the unexpected happens.
Case 3: A New Narrative Develops
There are many new narratives that could take hold.
As investors, we should continue to monitor financial and social trends to try and identify changes in their early stages.
Let me highlight one possibility.
What happens if inflation is completely left unchecked?
Here is what I am thinking. Housing inflation is running at 20%+. Rent inflation around 18% and rising. Electricity costs near 30%. Natural gas might be as high as 50%. And don’t get me started on food inflation.
These are all areas that impact the middle class and the poor harder than the wealthy.
It is just a function of a percentage of budget. If your monthly income is $3,500 per month then those increases are going to bite much harder than if it is $7,000 per month.
What is the human response to a situation like this?
It likely goes something like this: I can’t make ends meet under these conditions. I need to do something. I’m going to buy stocks/real estate/crypto/gold/silver/cars/diamonds whatever to try and survive.
If this mentality takes place, I would imagine a serious cyclical problem could develop.
High inflation raises cost of living, which creates a desperate middle class, which forces them to take more risk, which drives up prices, which fuels more inflation. Rinse and repeat…
Remember, if interest rates are not allowed to go higher, this type of behaviour is actually quite rational.
Let’s not get too carried away with conjecture. All I’m saying here is that we need to be aware of new narratives that may take hold.
One more thought…
Sometimes you just have to stand back and look at how much change has taken place over certain periods of time.
Going back to the average house price in Nanaimo graphic above, the average price has increased 400% over the past 20 years and increased 75% in the past four years.
Those are amazing changes relative to long-term historic trends, and they are also significantly larger than average wage/income gains.
Just 10-years-ago, in 2011, the largest company in America was Exxon Mobile by revenue ($452 billion) and Apple by market capitalization ($510 billion). As for individuals, Bill Gates and Warren Buffett each had net worth’s of about $50 billion.
Today, Apple is worth about five times as much as 2001, at $2.4 trillion.
Maybe more amazing, Elon Musk, the CEO of Tesla, has a personal net worth of $310 billion, which is nearly as much as the largest company in America just 10-years-ago!
Everything presented above required the narrative of “low interest rates forever” to happen.
It requires that narrative to never die in order to survive.
Perspective is important.
On that note, Megan and I hope you have a SPOOKTACULAR weekend, and if you’d like to set up a time to discuss your portfolio, please send me an email and we can connect next week.