Will Interest Rates Ever Be Normal?

Interest rates are at historical lows and have been low for a long time. Last night Janet Yellen, Federal Reserve Vice-Chair, said rates should stay near zero until late 2014. The WSJ quoted her: “Some of the Fed's internal economic models, in fact, suggested rates should stay low for even longer than planned, she noted.” Numerous bearish economists have forecasted the economy will remain weak (which means low interest rates) until 2016 or 2018 or even 2023. This reminds me of the concept that it takes years to recover from a burned down home but only an hour for it to burn. It will take along time for the unemployed to admit they were wrong about their old career, get retrained, get a trainee job and then become a fully experienced professional worker in a their career. This can't happen instantly, which is why it takes so long for interest rates to return to normal.

The Key To Low Interest Rates

The key reason for low interest rates is low inflation and high unemployment. Ultimately it is high unemployment that really forces the Fed and the bond market to keep interest rates low. The employment to population ratio has been stuck at record levels during the current recession and can’t seem to improve. The reason the unemployment rate dropped was due to people dropping out of the workforce, so the unemployment rate is poor quality gauge of unemployment; it is the employment to population ratio that gives the clearest view of the economy. The current levels of interest rates are justified; the bond market vigilantes are not asleep, instead they agree with the market price of interest.

To protect themselves bond investors should dig deep beneath the headlines to study the details of unemployment data to see if employment is increasing. Economist Dave Rosenberg said that the march employment report showing 120,000 new jobs should be 76,000 when adjusted for warm weather. My opinion is that since 120,000 new monthly jobs are needed to meet the needs of an increased population then the economy lost 49,000 jobs in March in "real" population adjusted and weather adjusted basis. Also investors should limit their exposure to long term or intermediate term debt to a level of interest rate risk that they can understand and tolerate, which may mean owning only short term bonds.

A “normal” interest rate would about 3% “real” plus 2% for inflation for a total of 5% for AAA rated debt, with a higher rate for long term debt or for a lesser quality grade of debt. When interest rates return to normal it will be harder to qualify to get a loan, so real estate may go down, business will be less able to expand and thus less hiring will occur. Stocks are valued in part by the discounted cash flow method, which in turn is influenced by interest rates. When interest rates go up then the discounting mechanism must reduce the present value of a stock, meaning that stocks will go down when rates go up. Stock bulls love to claim that a rate cut will make stocks go up. So they are implying that when rates go up then stocks will go down. Of course rising interest rates are the sign of a healthy economy which can increase corporate profits that may offset the damage to stock valuations caused by higher interest rates. (However, ultimately the PE10 method implies stocks are overpriced, but that's a different topic).

Long term and intermediate term bonds will go down in value when interest rates go up. Thus a recommendation today to buy them should be viewed as a “trade”, not an investment, although bonds will probably be a good asset to own for several years. I say “trade” because one must be alert for the return of high interest rates that would hurt bonds. Of course even the best quality stocks after a decade can become undesirable investments.

About the author

Don Martin, CFP®

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