10 Observations regarding Record Low Interest Rates

Investor’s Corner with Jack Brown

A 10-year Treasury bond doesn't tell you everything about interest rates, but is a pretty good reflection of the broad environment. As of Friday, a 10-year bond issued by the U.S. Treasury yields 1.61%. How low is this? It's not an absolute record low, but based on year-end values, it's never been this low (i.e. the past 130 years or so).

What does this tell us?

1) Bond investors aren't too worried about inflation. Think of it this way: if you're going to lend the government $100, and they'll give you back your $100 in 10-years, shouldn't you be compensated for the risk that your $100 (in ten years from now) will buy less things? If bond investors were truly worried, there's no amount of government intervention that would stop the rising tide.

2) it's a great time to borrow money. Now is the opposite of 1981. Clearly owning a 10-year bond that yielded 17% would have been a great investment back in the "Raiders of the Lost Ark" days. Today, it's much better to be on the opposite side of the transaction (assuming you know what you're doing).

3) Gold prices can stay at elevated levels with low rates. When rates do finally go up, yields on money markets will rise and pay more than inflation (this would actually and surprisingly be the normal arrangement). When this finally happens, the incentive to own gold will be lessened.

4) Investors who need income have to take more risk. Because a 10-year treasury bond, for example, isn't yielding more than inflation (by most estimates), investor's need to take a higher level of interest-rate (think longer maturities) or credit (think corporations) risk. Basically, finding investments today with yields higher than 3.5%, sounds reasonable, but is not as straight forward as it used to be.

5) For the first time since 1959, we are in an era where dividend yields on stocks are higher than risk free treasury bonds (on average).

6) The Federal Reserve (the "Fed") is targeting ultra-low rates. They do this by buying bonds (flooding the banking system with cash) and by adjusting the rate it charges banks for direct loans. When they finally get worried about inflation, they'll reverse course.

7) The Fed is currently paying banks on reserve assets, thereby reducing the incentive for banks to lend money. Right or wrong, this has helped banks earn profits and clean up their balance sheets. When it's time to reduce the excess reserves, they'll cut off this incentive and banks will lend them out. That would be further stimulation.

8) Interest rates could stay low for a long time. Japan has been dealing with low rates for close to 20-year despite loads of government debt, and efforts by the Japanese government to devalue their currency (this usually leads to higher rates). The US had low rates from the early 1940s to the mid-1950s and a lot of government debt.

9) Incentives for businesses has changed. Corporations raise capital either by issuing stock or borrowing money (loans or bonds). In the 1990s, a company could raise a lot of money by issuing stock without diluting other stockholders. With lower price-to-earnings ratios today, every dollar of stock issued has a higher dilutive affect. On the other hand, it's quite easy to borrow money and pay a low level of interest. A lower cost of capital helps drive margins higher - we're at high margin levels (a green shoot?)

10) Don't wait forever to refinance. Low rates could last a while, not necessarily. Finally, Uncle Sam has made it rather easy to refinance if your mortgage is owned by Fannie-Mae or Freddy-Mac. Figure out the "payback period" on the cost of a refinance, and if you'll be staying put for more than that period, chances are it's a good deal.

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