Positive interest rates are such an embedded cultural norm that Wimpy’s offer to Popeye, written by E.C. Segar in 1934, that he’d “gladly pay him Tuesday for a hamburger today” was often heard nearly a century later. And it never lost its hilarity and relevance as a wisecrack…until now. With over $7.8 Trillion (and growing!) in negative interest rate loans in the global market place today, it’s as if investors the world over were flocking to Popeye’s restaurant begging to pay right now for a hamburger next week. If we bought hamburgers with $7.8 Trillion and stacked them up, we could eat hamburgers all the way to the moon. It’s an incredible sum paying for the privilege of being lent. “Please take my money, I’ll pay you when you decide to give it back.” You can’t make this stuff up. Milton Friedman would roll over in his grave.
This note focuses on the history of interest rates and the consequences of changes in interest rates levels. There is an effect on both asset prices and portfolio strategy. We first take a (very) long term look at interest rate history and where the current levels are relative to that history. Then, we discuss three important investment implications of very low historical rates and briefly touch on some portfolio strategies we can use. Future notes will focus more directly on strategy.
Interest Rate History
Interest rates are low now and have been falling for thirty-five years. But before that 1981 peak, interest rates rose for thirty-five years. In order to put things in perspective, let’s take a very long look at American 10-year Treasury rates. This is the interest rate paid by the United States government on money borrowed for a period of ten years with a bond issued in exchange for funds. Below is a chart attributed to Bank of America Merrill Lynch’s Michael Hartnett (and the research team at BofA ML).
During this period Hartnett references five different rate change periods
1790-1902: Erratic yield fluctuations and then a sustained decline in yields to below 3%.
1902-1920: The First Bear Bond Market, yields rise from 3% to 5-6%.
1920-1946: The Great Bull Bond Market, yields decline from 5-6% to below 2%.
1946-1981: The Second Bear Bond Market, yields soar from 2% to above 15% during 1981.
1981-present: The Greatest Bull Bond Market, as yields tumble from 15% to 1.4% in 2012 (and under 1.6% earlier this year).
However, we can “zoom out” even more! Last September Business Insider’s Elena Holodny presented an even longer term chart (this one prepared by Bank of England and Global Financial Data).
Andy Haldane of the Bank of England provided the following annotated list of key historical episodes and the corresponding interest rate of the time:
3000 BC: Mesopotamia: 20%
1772 BC: Babylon, Code of Hammurabi: codified earlier Sumerian custom of 20%
539 BC: Persian conquest (King Cyrus takes Babylon): rates of 40+%
500 BC: Greece, Temple at Delos: 10%
443 BC: Rome, Twelve Tables: 8.33%
300-200 BC: Athens/Rome, first two Punic Wars: 8%
1 AD: Rome: 4%
300 AD: Rome, under Diocletian: 15% (estimated)
325 AD: Byzantine Empire, under Constantine: limit 12.5%
528 AD: Byzantine Empire, Code of Justinian: limit 8%
1150: Italian cities: 20%
1430: Venice: 20%
1490: Venice, (Leonardo da Vinci paints "The Last Supper in Milan): 6.25%
1570: Holland, beginning of the Eighty Years' War: 8.13%
1700-1800: England: 9.92%
1810: US, West Florida annexed by the US: 7.64%
We see that global interest rates are currently at or very close to the lowest interest rates in 5000 years. Certainly the interest rate “ride” of the past 35 years looks like a historical anomaly and unlikely to continue indefinitely. What are we to make of this and what are the implications to us as investors?
Investment Implications
Think of interest rates as the “price” of borrowed money and also correspondingly as the rate of return on loaned money. More borrowers and less lenders means rates go up. More lenders and fewer borrowers mean rates go down.
Declining interest rates also mean increasing bond prices. For example, if we were to buy a 10-year US Treasury bond yielding 5% and the 10-year US Treasury interest rate subsequently fell to 3%, the market price of our bond would increase (because in an open and liquid market trading at 3% would mean that the price of each similar bond would adjust up or down until a buyer of any of these similar bonds would earn the same 3% market rate.)
The following example from thismatter.com shows the effect of interest rate changes on bond prices (in this case a bond with a coupon of 6%:
“Bond prices — not including accrued interest — vary inversely to market interest rates: bond prices will decline with rising interest rates, and vice versa. Bonds with longer effective maturities, or durations, are more sensitive to changes in interest rates, as can be seen in the diagram below, showing the price/yield curves per $100 of nominal value, as the market interest rate varies from 1% to 16%, for a bond with 3 years left until maturity and one with 10 years left, both with the same 6% coupon rate and paying interest semi-annually. Note that both curves intersect at $100 when the market yield = coupon rate of 6%.” (thismatter.com)
If you are with me so far, here is first of three important observations for investors:
Over the past 35 years, fixed income (bond) investors have greatly benefited from the general decline in interest rates because they have earned the yield of their investment PLUS the price appreciation of the bond due to falling interest rates.
When we look at a broad measure of the US bond market (in this case the Barclays Aggregate Index), we see historical annual returns on bonds exceeding 8% since 1980. This represents the combined return of both the bond yield and the price appreciation that occurred as interest rates fell.
The US Federal Reserve (Fed) began the process of inching rates back toward what they consider as long-term normal last November. The Fed estimates short term interest rates in the 2%-3% range (roughly equivalent to the long term inflation rate) to be the longer term steady state level. This roughly corresponds to US Treasury bonds yielding something like 4-6%. Currently the 10 year US Treasury yield at 1.9% is more than 3% below the mid-point of this range.
If interest rates trend upwards towards this longer term steady-state range, investors could expect to again earn the bond yield plus the price appreciation due to declining rates. But as interest rates rise, this price appreciation is now negative rather than positive. So fixed income investors find themselves between a rock and a hard place. With Treasury bond interest rates below the rate of inflation, the offer little return and with little room for rates to fall further (pushing up prices). If rates simply remain where they are today, meager yield offers very little investor return. If rates rise, this small yield offers little cushion against the accompanying decline in bond prices. At minimum, today’s bond investors have little reason to believe that their forward-looking returns will resemble recent historical returns.
And now the second point. The interest rate impact on asset prices has not been isolated to bonds.
As rates have fallen many other asset prices have also benefited via substitution and financing effects. This means that these other classes of assets (like stocks and real estate) have also had the advantage of an interest rate tail-wind in recent decades.
As an example of the substitution mechanism, imagine a recent retiree faces an investment decision. She can either buy a 5-year Treasury Note paying a 5% yield (as was common just a few short years ago) or invest in the stock market with obvious additional risk in the hopes of achieving additional return. Her choice would depend on her need for income, risk preferences, and overall financial situation, but a reasonable approach would be to own some of each of the options as many actual investors have done for years (i.e. a typical 60/40 stock/bond portfolio). Now what happens when the bond pays close to 2% and our same investor has the same need for return and yield? It gets much more tempting to “reach for yield” and increase the percentage allocated to the stock.
Extend these types of substitution decisions across the global asset market place, and we can certainly understand how declining yields in one area of the market could affect prices and yield in other areas of the market. Data seems to confirm this effect. Using the same post 1980 time-frame as before, see the following chart of S&P 500 earnings yield and 10-Year Treasury yield over time:
Keep in mind that as stock prices increase for a given level of earnings, the earnings yield will decline since it takes more money to buy the same amount of yield.
We can also derive financial transmission mechanism from lower interest rates to higher asset prices based on borrowing prices. For example, a house is typically purchased with a fixed rate mortgage. Putting 20% down and assuming a 30 year fixed rate mortgage, a $250,000 home could be bought for a monthly payment under $1000 at a 4% mortgage rate. However, if mortgage rates were to rise toward 7%, the same monthly payment would only buy about $180.000 worth of house (assuming other variables stayed constant). Data upholds this directional relationship as a national home price index rose roughly 400% since 1980 as interest rates fell from over 18% at their peak.
Another example of financial transmission would be an institutional investor (think bank or hedge fund or manufacturing company) with a borrowing cost of 5%. If an investment opportunity yielded an expected return of 8%, the investor could borrow at 5% and earn the spread of 3% (8%-5%) between the investment return and his cost of borrowed funds. If the investor’s borrowing costs fell to 2% due to a general decline in interest rates, the “hurdle” or necessary expected return, falls also. So this investor could now afford to pay more for the same opportunity because even a 5% expected return yields the same 3% expected spread (5%-2%). Thus substantial and sustained changes in interest rates permeate the economy as a whole providing capital gains to current investors and reducing yields (and expected forward-looking returns).
In addition to these return and asset price effects of a prolonged period of declining interest rates, there is also an important portfolio strategy implication.
During periods of very low interest rates risk reduction is difficult. Volatility often rises while traditional diversification may be both costlier and less effective.
It has been shown that when interest rates are low, asset correlations (statistic measuring how closely the direction of movements are “linked”) and volatility often increase (statistic used to measure risk). Increased correlations mean diversification provides less “bang for the buck” because a portfolio of assets that move independently of each other provide risk reduction, whereas if the asset prices increasingly move together (increasing correlation) the portfolio risk becomes closer to simply the sum of each asset’s risk, reducing the benefits of diversification.
Furthermore, as interest rates decline, the loss of equity risk premium (the additional return historically available to stock holders in excess of the return available to bond holders) becomes proportionally more important. Note that the following table is for mathematical illustration alone and represents neither actual past or expected future returns. If stock and bond returns were separated by a 5% equity risk premium, we can compute the returns of a 50/50 mix of stocks and bonds at various rates returns. Of course this is a complex and non-linear relationship, in real life. However, the point here is that in a low general interest rate environment, alternative sources of return (for example, the equity risk premium in this case) grow increasingly important.
Tacking Into Possible Headwinds
In summary, we can draw a few specific conclusions:
• The investor experience of the most recent 35+ years since 1980 was relatively unique within a long span of history because of the magnitude and persistence of interest rate declines over that period.
• Based on historical data, this seems unlikely to continue for much longer. In fact, it appears that this downward trend in rates is likely to at least end and possibly be reversed in the future.
• If this historical interest rate tailwind subsides, or potentially reverses into a headwind, asset classes that benefited previously from the downtrend in rates will at least have this advantage removed and could potentially face an interest rate disadvantage for some period of time.
All of this has a somewhat negative tone, and it is important to note that the outlook is not negative at all for the investor willing to think outside the box. Using longer-term mean reversion among asset classes is important. Certain areas of emerging markets and commodities look historically undervalued. The recent trends that have left US stocks and global bonds well above long term averages have been nearly mirrored (in the negative form) in many markets ranging from Copper, to Natural Gas, to Oil, to Brazilian, Indian, Chinese, and Russian stock markets. The headlines in the former asset classes are optimistic, and cheerfully hopeful. The news on emerging markets and commodities are scary and negative. The setup in such unloved assets therefore appears quite attractive to the patient long term investor.
Another way to think outside the box involves looking for ways to purchase “insurance” against the under-performance of a specific group of assets. One of the best assets to hedge against “systemic” risk has always been gold because of its nature as a currency, its portability, and its liquidity. In a negative yield world, the fact that gold is just money and doesn’t pay a yield becomes a positive trait rather than a negative one. Other real assets without associated liabilities can serve a similar role.
Our forward-looking strategy toolkit includes:
• Using long term mean reversion concepts to look for unloved and under owned assets.
• “Store-of-value” type assets with inverse correlations to traditional financial assets.
• Taking advantage of expected increased volatility by raising cash balances and deploying into market sell-offs.
• Limiting exposure to relatively overvalued areas of the equity markets.
• Reducing bond exposure and minimizing the duration of bond holdings.
At some point in the future interest rates will approach a more viable level. Until then, we need to be aware of the headwind potential, nimble, and ready to engage in tacking into the wind. Taking a macro view in the search for undervalued and unloved assets (particularly ones with low correlation to our other holdings) is always good investing strategy. We plan to continue this discipline under all circumstances.
References
BofA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg, 2016
Business Insider, 2015, <http://www.businessinsider.com/chart-5000-years-of-interest-rates-2015-9>
Business Insider, 2015, <http://www.businessinsider.com/10-year-us-treasury-note-yield-since-1790-2015-2>
Haldane, Andrew, “Growing, Fast and Slow” Bank of England 2015
http://www.calculatedriskblog.com/2013/06/house-prices-and-mortgage-rates.html
MULTPL, 2016, <http:// www.multpl.com> (Chart Data)
Bankrate, 2016, <http://www.bankrate.com>
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