Ripple Effects Of Low Interest Rates

This article was originally published at The HumbleDollar

I still consider myself one of the younger folks at the energy trading firm where I work. The more tenured employees will sometimes talk about the early 1980s, when mortgage rates were north of 10%. “Try paying that down quickly,” they’ll quip, as we watch the 10-year Treasury note yield scroll by on the ticker—at around 0.7%.

I never thought interest rates would stay this low, especially given the recovery since March by both the stock market and many economic indicators. Just recently, the ISM manufacturing and services indexes were at 16-month and 17-month highs , respectively, though many pundits say the U.S. economy won’t fully recover from the COVID-19 crash until perhaps late 2021.

Still, for now, Treasurys are basically at all-time lows, no matter which part of the yield curve you look at—and that has five major implications:

1. A negative real risk-free rate. The yield on Treasury bonds, especially the 10-year note, is often considered the risk-free rate, meaning it’s the return you can earn while taking minimal risk.

But that risk-free rate isn’t looking terribly tempting. Annual inflation is running at just 1%. Inflation expectations for the next five years are under 2%. Nonetheless, those inflation rates are above both short- and intermediate-term Treasury yields. That means the after-inflation “real” interest rate on Treasurys is below 0%.

To earn inflation-beating gains, savers are relegated to taking more risk in higher-yielding corporate bonds or even the stock market. And, no, the bank isn’t an alternative: During much of the 1980s and 1990s, savings accounts earned 1% to 4% after inflation. Today, the real yield at many banks is often more like negative 1%.

2. Stock valuations are higher. Stock market bears love posting charts of the S&P 500’s price-earnings (P/E) multiple . Right now, it’s sky high, no doubt about it. But a key factor in determining stock valuations is current interest rates, especially Treasury yields. The lower those yields, the higher stock valuations tend to climb.

Recall the early 1980s again, when the earnings —a level that reflects not only record low interest rates, but also depressed corporate profits. Good luck to those waiting for a return of single-digit P/E ratios on the S&P 500. Unless interest rates rise sharply, it’s very unlikely to happen.

3. Government debt isn’t a big risk—for now. U.S. government debt has soared to nearly $27 trillion . But take heart, it’s nothing to lose sleep over. You should be concerned about your health, how your kids are doing in school and paying the bills, not your share of government debt. Thanks to rock-bottom Treasury yields, the interest our nation pays remains manageable.

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4. Mortgage rates are dirt cheap. I’m not looking to buy a house any time soon. But for those in the market, what a time it is to be alive. Thanks to low Treasury yields, which are used to benchmark mortgage rates, borrowing costs are tiny.

refinancing if your mortgage rate is north of 4% and you still have a big outstanding loan balance.

5. A weaker U.S. dollar. Market watcher that I am, it’s hard not to notice the drop in the dollar over the past few months. Gold stocks and raw commodities surged earlier this summer. Emerging market stocks were even beating U.S. shares for a time. Falling interest rates mean foreign investors are less inclined to put money to work in Treasurys, so demand for the greenback has waned.

Borrowers, savers, retirees, young investors and international travellers (if that’s even a thing any more) are all affected by these unprecedented low interest rates. Maybe one day I’ll be that tenured guy at the office, telling the youngsters about the good old days of a 2.5% mortgage.

Written By: Mike Zaccardi, CFA, CMT