Blackers Blog

Interest Rates: Where Are They Heading?

If you ask most people what they know about interest rates, they might just about be able to tell you what their current mortgage rate is. If you ask them about the ‘yield curve’ and where rates are likely heading, you will almost certainly get a blank stare and a swift change of subject!

The point being that most of us know virtually nothing about what interest rates are, why they move and where they might be going, and yet we are seemingly quite happy to take on large debts, either for a mortgage or business loan, with the view that as rates are currently low it’s a good time to borrow more and ‘she’ll be right’.

This attitude has prevailed in many places around the world, and because of the resulting debt that has been amassed, our debt servicing costs will become crippling should interest rates start to rise.

We will discuss what the future for rates holds in a moment, but firstly let’s look a bit closer at how interest rates are generated.

 In most Western societies the process is pretty similar in that the Central Bank sets the rate at which banks lend to each other overnight (In NZ this is known as the Official Cash Rate or ‘OCR’).

 Under normal circumstances this is the only rate over which the Central Bank has direct control. There are then a range of Government bills or bonds of various durations, ranging from one month to thirty years depending on the particular country.

These bonds pay a fixed dividend or ‘coupon’, but the price you buy or sell the bond at can move up or down and is decided by the marketplace, as a result of this relationship the interest rate of the bond moves inversely to the price of the bond.

 For example:

At Issue

 Price of Bond  $100    Coupon $10     Interest Rate  10%

Bond Price moves up                              Rate goes down

 Price of Bond  $125    Coupon  $10    Interest Rate  8%

Bond price moves down                         Rate goes up

 Price of Bond  $ 75      Coupon $10    Interest Rate  13.33%

It is worth noting therefore, that Central Banks the world over cannot control the yield curve, only the ‘overnight rate’, unless they directly intervene by buying bonds of longer duration, as many are now doing via Quantitative Easing.

In a ‘normal’ market, the interest rate increases as you move out along the ‘yield curve’, meaning that 10 year bonds will have a higher interest rate than 5 year bonds, which will in turn have a higher rate than 2 year bonds, etc.

This can be illustrated in the chart below of a stylized ‘Normal Yield Curve”

This intuitively makes sense. As a lender you would justifiably expect to earn more in interest the longer your money was tied up.

 However, there are numerous factors that can affect the yield curve, including – economic growth and inflation expectations, perceived investment risks, changes to taxation regimes, political uncertainty, comparisons to alternative investments, changes in the liquidity within the financial system, and as already mentioned direct Central Bank intervention, often making the reality anything but ‘normal’.

Interest Rates though are like most other things in that they follow a long term trend. So where in that trend do we currently stand?

Well, New Zealand is currently enjoying some of its lowest interest rates for decades. The same can be said for the majority of developed countries, as globally rates have been trending down for over thirty years, caused by a combination of low inflation, relatively high returns on investments and a seemingly inexhaustible supply of easy credit.

The chart below shows the US 30 year mortgage rate (an excellent proxy for global interest rates), and the extent and duration of the move is quite apparent.

We can see that although there have been periods of rising rates, sometimes lasting for a few years; the long-term trend has clearly been down.

If we now look at a longer term chart of the US Federal Funds Rate (the ‘overnight rate’) we can see that prior to the collapse from the highs of 1980, interest rates actually staged a thirty year rally!

So putting the information from these charts together, we can confirm that interest rates do move in predictable long –term cycles, with rallies and corrections along the way, and that with rates at their current generational lows and factoring in the number of years that they have been falling, it would appear that the downtrend in place since 1980 should shortly come to an end.

However, things may not be quite that simple.

Remember I said earlier that the period since the 80’s was driven by easy credit, good investment returns and low inflation? Well whilst that may have been the case in the early years, it slowly morphed into a low investment return, high inflation environment where more and more credit was used to paper over the cracks.

 As we now know, the collapse of this house of cards ultimately lead to the 2008 global financial crisis, and it is the actions taken by Central Banks around the world to try and stimulate growth that has pushed rates to these historic lows in the years since.

Unfortunately, once interest rates are down at these very low levels, the action of cutting them even further to stimulate the economy tends to have very little impact (the so called ‘pushing on a string’ effect).

And irrespective of low rates, the unwinding of the excessive debt burden will lead to numerous countries defaulting. There is no way to stop it.

So with these repercussions rolling on for the next few years, Central Banks will likely keep rates low for some considerable time, and that is precisely what I expect them to do.

But as we now know, they do not control the entire yield curve (at least not without creating other major problems – there is no free lunch!), and as we can see from what is unfolding in Europe with Greece, Spain, Portugal, Italy etc, even with low ‘overnight rates’ once the marketplace senses that a country is in trouble and might not repay it’s debts, its bonds are sold aggressively and interest rates rise dramatically compounding the problem and making default even more likely.

This is what we are currently witnessing. Like a giant queue of naughty schoolboys lined up to take their punishment, ranked in order of how bad they’ve been, with the Greek kid at the front. And once he’s had his six of the best, it’s the Spanish kids turn and so on.

So we in New Zealand may currently be basking in the warm glow of low interest rates, but as the sovereign debt crisis unfolds and builds, moving from Europe through Japan and finally the US, at some stage we will be number one in the queue, and as we have seen from the charts above, when the trend finally changes interest rates have a hell of a long way to climb.

So is now a good time to take on debt because of historic low interest rates?

Well, if you can weather a substantial rise in rates and still be ok, or if you intend on paying down the debt over the next 2 to 3 years then the answer may be yes. But if you are relying on rates staying where they currently are over the long term, the future will likely be very painful indeed.

Just ask the Greeks.