Interest rate trend will change

On October 20, 2012 by Phil Champagne

By Phil Champagne, Managing Partner at Wren Investment Group

This investment vehicle is influencing the yield (return on investment) of all other type of investment. It, along with the US federal deficit, provide a very good guidance of the level of price fixing the Federal Reserve is doing. What happen with price fixing is always the same – it distorts the market. However, no matter what kind of price fixing might be done by the government, the free market eventually always win, usually correcting the price violently.

Let’s observe with attention the following chart below of the yield (interest rate) of the 10 year treasury bond. Note that the yield is inversely proportional to the bond’s value so this means currently the 10 year treasury bond are at a record high never reached before. Visually, we can see the mean value over more than 100 years this chart represents is somewhere between 3.5% and 4.0%, perhaps a little higher. Currently it is around 1.8% (October 17, 2012).


Prior to 1913 when the Federal Reserve was created, we can see the interest rate varied between 3 and 5.5%. During the great depression, with the help of the Federal Reserve pushing rates artificially lower, they went as low as 2%. From there they slowly started to rise towards a very high peak of 14.5% in 1981. Since then, they have dropped down to below 2%. We see low and high peaks in 1920, 1940, 1980 and today and they are getting more pronounced over time.

This rate below 2% is artificial and like any price fixing, it ends up with a huge correction on the other side. We can expect the yields to move to the upside in a more spectacular way than it did in the later half of the 1970s. I personally expect this to happen within the next 6 years. Any new commercial loan with a fixed interest rate for the next 10 years will go beyond this trend change and  the owners will have to face the much higher interest rate when refinancing is due. However, by that time, the income will be much higher as well and will allow such refinancing in a higher rate environment without any issue. We will have some good warnings before such move in interest rate will happen: watch the price of gold, the canary in the coal mine. When gold, a competing currency, starts to move more rapidly to new higher level, it will indicate the bond investors disqualifying the treasury bond as a safe, secure and preservation of wealth.  This will put pressure on the Federal Reserve to let the Treasury bond provide a sufficiently higher enough real interest rate (not nominal interest rate) so it can compete with gold, just as Volcker did in the 1980s.

Interest Rates

Interest Rates (Photo credit: 401(K) 2012)

The question will be then: what portion the interest payment on the debt will it be on the federal government’s yearly expenses then? I’ll let you imagine what an interest rate in the teens (or above) would do on the budget when you look at this debt clock:   Right now, the interest payment takes around 7% of the federal expense at these very low rates, with a large portion in short term treasury bonds at less than 0.5% interest rate. With Washington having a track record demonstrating its preference for a higher spending, the US being the biggest debtor nation of the world (as opposed to creditor nation in the late 1970s), unfunded liabilities and ever increasing deficit (based on the track record) this doesn’t get the most comforting thoughts. But let’s see how it plays.

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