The Price of Money - 700 Years of Falling, Can Interest Rates Keep Rising?
24:38 Share

What kind of money for the rest of us? This is a personal financial on money, how that works, how to invest in and how to live without worrying about IT arma host David stein, today is episode four fifty three. It's title, the Price of money why interest rates are unlikely to stay this high.

Earlier this week, the ten year nominal treasury bond yield exceeded five percent for the first time since two thousand seven sixteen years ago, ten year real yields are approaching two and a half percent, also the highest level since two thousand seven. Interest on thirty year mortgages in U. S.

Are near eight percent, the highest since year two thousand. That is shocking, given that two years ago, the interest rate on thirty year fixed mortgage was less than three percent. An interest rate is the Price we pay to borrow money.

What's more Normal? A three percent thirty year fixed mortgage or in eight percent thirty year fixed rate mortgage? Most of the homes we've owned have had thirty year fix rate mortgage between six and eight percent.

But two years ago, in twenty twenty one, we took out a mortgages for the first time and over a decade in order to help fund our homework model. We were motivated to do so because we were able to lock in a rate of three percent. In the past few months, we've explored different aspects of interest rates.

We looked at insights from the kind of city federal reserves annual symposium that was an episode four forty eight and and looked at what was driving interest rates and what these economists and central bankers thought. In episode fifty, we considered six impacts of higher interest rates on housing capital projects, stocky by bags, opportunity cost. In episode fifty one, we looked at why are allocation to rescue assets like stocks should be lower if we, he can earn a higher risk free rate, in this case, five percent risk free in the current environment.

And then last week, and epsom four fifty two, we looked at investing in non investment grade bonds, leverage loans and preferred stocks because they are expected to return to so compelling relative to common stocks. We keep going back to the same thing because rata size, we've been in sixteen years. We really want to understand what is going on in order to make effective investment decisions.

Here's a fascinating quote from bloomberg economics. They right, investors are finally coming to grips with the realization that something fundamental has changed. Money is going to stay expensive for a good long while and not just because it's taking longer than expected for the federal reserve to wrestle down inflation.

Is that true? What will look at two views that, that is the case, but then we will look at one that puts what's going on today with interest rates into long term historical context. And by long term, I mean, over seven hundred years of interest rates, bloomberg economics points out that the Price of money, like the Price of many things, is driven by supply and demand.

In the case of interest rates, the supply is savings. How willing are workers and others to save money and to invest in lower risk assets like U. S.

Treasury bonds? What is the supply of that savings? The domain comes from the desire to borrow, the desire of the government to borrow in order to invest in infrastructure projects or corporations to borrow, to invest in projects like a new plant or factory that they feel will help their company grow.

So we have barriers that demand the investment, and we have the savers, though those that are, are willing to land, willing to buy bonds. And there's an equilibrium. And that equilibrium is a term we've used in the past, is sometimes called the neutral real rate of interest.

And by real native inflation, sometimes is called r star. Another term is the natural rate of interest, and it's that interest rate that baLances savings and investments. And that said, at a level that there's not too much demand to borough, so the economy overheats leading to inflation, but IT can be too high so that no one wants to borrow at the current rate.

The chAllenge with figuring out this natural rate of interest is no one is really sure what that is. It's kind of A A guessing game. In fact, some economists and central bankers aren't even sure whether it's even effective to speculate what IT is because it's so difficult to pin down that IT.

Maybe it's Better to just look at where things are currently and adjust interest rates like a die now this sort of turn them up or down as we talked about a few episodes ago. But the takeaway is, is there there's a supply of savers and there's the demand from borrowers, the bar money and then that Price of money, the interest rate settles down at some level. Bomberg economics discussed why over the past sue decades, that natural of interest, that neutral al ative interest, fell from round five percent back in one thousand and eighty to generally less than two percent over the past decade, except now it's close to two and half percent.

One reason that IT dropped is we've had weaker economic growth over the past few decades, so there's been less demand to borrow because the opportunities weren't as great. The same time, we've had baby bombers and others saving more for the retirement. So there was a lot of savings.

In fact, there was some speculation that there was a savings glut, too much savings, and that was putting downside pressure on interest rates. The same time, us was running big trade deficits and countries such as china had a lot of dollars that they in turn invested in us treasury bonds. Now bloomberg economics is suggested because baby boomers are leaving the workforce now, spending down their mistakes that eats into the supply of savings.

At the same time, china is not buying as many U. S. Treasury bonds. In fact, there is some evidence that they might actually be reducing their tragedy. Bond holdings. We definitely have the central bank, the federal reserve letting the bonds that IT purchase ed through quantitative easing mature. And so they're not necessarily buyers of bonds.

And the government has been running huge budget deficits, as we talked about a few episodes o and so there's a big supply of government bonds being issued and that has made to higher interest rates. The question is, is this temporary or is this gonna be a longer term trend? Bloomberg economics model suggests that neutral al rate of interest had a trough of about one point seven percent in the mid twenty tens, and they expected to be two point seven percent in the twenty thirties, about where IT is now, so for another decade having higher real rate of interest.

Another economist that has a similar view is Thomas s. William c, who is the chief european economist at t row Price. He wrote an essay in the financial times recently, and he pointed out how active government have been in the government bond markets, providing demand for those bonds, buying them up where the bank of japan owns more than fifty percent of japanese government debt, and so that marginal buyer be at the bank of japan, the european central bank, the bank of england, the federal reserve.

They were present sensitive. They were buying bonds, government bonds, in order to reduce the supply and put dow ward pressure on interest rates. But now they're not, at least to the degree they are not. And because of that, because it's now the individual the private investor that is the marginal buyer of government bonds, not central banks, that, that has made to an increase in the term premium, additional compensation that those individual investors as private investors want to purchase government bonds. And we seen the term premium go positive for the first time in three or four years.

It's been a negative term premium for most of the time since twenty sixteen because the marginal buyer, that incremental buyer was generally a central bank that was just buying without caring what the rate was, an attempt to push interest rates down. I admit interest rates can be complicated because we talk about the theory of what drives interest rates, that the level of interest rates is determined by expectations for what future short term rates will be, what the central bank will set their palaces rate, that sort of the a baseline. And then inflation expectations can influence what the rates are.

And then they're the third element, the term premium at any additional compensation to protect against uncertainty regarding inflation of what central banks are doing. Now that's that's the theory of interest rates. But then in practice, buyers and sellers that might have these theories is driven by supplying demand.

How many savers there are and how much demand is there to issue debt to fd investments to fund capital projects is out of having two views of IT, the theoretical view and the supply and demand view. So there's the view point out there then that the real rates that were seeing now in the U. S.

And other countries around the world a higher level than we've seen are here to stay because of the large government budget deficits, because baby boomers are retiring. So there's less savings going around and because their marginal buyer is no longer a central bank that's Price and sensitive. But individual investors, institutional investors that are, are more wary.

And so the term premium could be higher yet. And this is what's fascinating. A listener sent me a paper that was released back in twenty twenty, the bank of england working paper by paul smelling.

He went back seven hundred years, looking for primary sources, written sources, to reconstruct a history of interest rates. And he, he did IT really doing a GDP waiting. So basing IT on, know which economies at the time with the largest, and waiting their interest rates more.

So we went back to the year thirteen eleven, and the average real rate of interest going back seven hundred years was four point six percent. We're at two point five percent today in the us. If we look over the the past two hundred years though, the average real rate of interest is two point three percent about where we are today.

On the other hand, that's going back two hundred years. We've seen and i'll definitely link to the paper in the shower note. You can look at a graph and see that over time, the long term trend is down for interest rates.

For example, we look at fifty year averages. It's generally a downward train, but there can be periods where that real rate Spikes. The long term trend for rates is down. The rate for inflation has actually been up.

The two hundred year average for inflation around the world waited by the size of the economy has been one point six percent, but the one hundred year average has been two point seven percent. So inflation has gone up. And that is one of the reason real rates have come down.

The author points out that up until they are eighteen hundred half of all years, about two hundred and thirty years actually saw Price declines, deflation. But now where in a period where inflation is higher and partly it's because the monetary system is no longer held captive to the supply of precious metals. We're not on a gold standard.

We're not on a silver standard. We're on A A fia at system where. Central banks working with the government can create unlimited money. It's our money is become unshackled and as result, a higher inflation.

But not only esty inflation higher, the other thing that's interesting is real rates are lower, but so is the volatility of both real rates and inflation so that the swings in interest strates and inflation are not as high today or the last fifty years. And we've been historically in the centuries y's past and negative real rates, something that when that happened a few years ago, I thought, well, this is highly unusual. Turns out over the past seven hundred years, twenty percent of the time advanced economies had negative long term real rates of interest.

Now more due today. So the long term have have been around twenty percent. But since two thousand and nine, about twenty six percent have experienced at least a short period of time of negative real rates of interest.

Before we continue, let me pause and share some words from this week sponsors. Before we continue, let me pause and share some words for one of this week sponsors. Net sweet.

What does the future hold for your business? Ask nine experts and you'll get ten answers. Ball market, bear market rate will rise or fall. Inflation upper down. Be great if we had a Crystal ball, but we don't.

Until then, over thirty eight thousand businesses have future proved their business with net sweet by oracle, the number one cloud E R P, bringing accounting, financial management, inventory, H, R, into one fluid platform with one unified business management way. There's one source of truth giving you the visibility and control. You need to make quick decisions with real time insights and forecasting.

You're peering into the future with actionable data. When you've closing the books and days, not weeks, you're spending less time looking backwards and more time on what's next. I know as our business growth, we'll certainly consider using net weet by oracle now whether your companies aren't millions or even one hundred of millions, next day helps you respond to immediate chAllenges and seize your biggest opportunities.

Speaking of opportunity, download the CF hos guide to A I A machine learning at net sweet that comes less. David, the guide is free to you at net sweet dot. Come slash David, net sweet that com slashed David.

Knowing where our mony's going in, how it's being spent, helps us feel more at peace. Monarch money is a Operated all in one personal finance that that gives you a comprehensive view of all your accounts, investments, transactions. In more, you create custom budgets like we do, can track your progress toward financial goals and collaborate with your partner and now get an extended thirty day free trial.

When you go to monarch money dot comes last, David. Monarch is the most customizable budgeting APP. You can change the layout of your dashboard.

And I have done that can tagle between light and dark mode. I haven't done that, but you can set up automatic rules for transaction. So, you know, haven't IT fix IT each and every time.

And best of all, monarch never sells your data to third parties or shows your ads. After trying monarch myself, I understand why it's a Operated personal finance APP. And right now, listening ers of this show will get an extended thirty day free trial when you go to a monarch money that comes less.

David, that's M O N A R C H M O N E Y. That comes last, David, for your extended thirty day free trial. What we drive this.

So why why would real rates of interest go down over time? And it's it's a long term trend. It's irrespective of the type of government, the type of monetary system, the politics wars.

It's been a long term trend, well, perfect to supply demand. As economies develop, they become more productive. So workers get higher incomes and they save that income. There's more capital available for companies and governments to to bar. So the supply of savings grow faster than the demand for investment and have a greater supply if the supplies growing faster than demand, that puts doward pressure on interest strates.

At the same time, because of technological advances, the amount of capital needed, particularly as the world has become more service ended and factories have become so much more efficient, agriculture has become so much more efficient, the amount of capital needed just isn't as great, and so the demand to barrow isn't as much, and that puts downward pressure on interest rates. Another reason is we live longer. We have longer life expectancies.

Olivia blanchard and economists point of this out in A P selling, too, but he believes this, this is important that longer life expectancies means people have to to save more in order to cover the retirement and the additional savings put toward pressure on interest rates. Another reason is an increased desire for safety to invest in a risk free asset that, that has changed over time, particularly as a volatility of government bonds has been reduced and the volatility inflation. So where they've become safer as over time, even though the rates have fAllen and that has attracted more investments into government bonds, we've also seen fewer defaults among advanced economies in the south.

Safety of the economy is increased in that attracts and investment in those bonds pushing down interest rates. We've had fewer panic where people are worried about the banking system or government finances. Now there's always worries about those things.

But because of central banks being the lender of last resort, willing to step in to save the day, that has reduce the perception of risk in investing in lower risk assets or even higher risk assets, it's provide a more stability. And so it's LED to a long term downward trend in interest rates. And money is just more flexible.

As i've mentioned, we're no longer tied to the gold standard. So there isn't a shortage of of money. So money itself, the ability to access IT to bar IT, it's much more readily available.

And so because of that, it's Prices cheaper and interest rates are lower. So we had a very, very long term downward trend in industries. Now it's not completely smooth that over a fifty year time horizon IT generally is there's times where it's platow. But if we look at seven year real rates, IT, IT does Spike and IT could be. We're in a period now where we're going to have a time of higher real rates.

One of the uncertainties is how much capital will be needed for investing for capital projects, for example, A I, or for geopolitics, building up spending on military, and given the military conflicts around the world, what governments feel like they need to boost their military spending and borrow the money to do that, that could put upward pressure on interest rates. The desire to be sure to take factories that word overseas and move that manufacturing on, sure that takes investment in new factories domestically, investment in Green energy, the energy transition, battery technology, there's all these things out there. So even though the long term trend is down, one could make the case for why things have fundamentally changed.

One benefit, though, of lower real rates of venture that we've seen for much of the past fifteen years very much helped household finances. The U. S.

Fear reserve does a study they released every three years. That's the survey of consumer finances. They just released the most recent one and went from twenty nine to twenty twenty two.

And they found that the real media network increased thirty seven percent between twenty twenty and twenty twenty two. This is real. This is not of inflation. So we've had inflation up over the past two years, but the actual real network has increased.

I actually found that surprising given the stock market sold off in twenty twenty two in housing Prices, a flat line, and the fact that the government created all of this money to combat the the pandemic. But after backing out inflation, at the end of the day, networks increased. The other thing that happened is debt baLancers went down.

The meaning amount of debt on primary residences for families between two and one thousand and twenty and twenty, you fell one percent to one hundred and fifty five thousand dollars, even though housing Prices are much higher, about forty five percent of families have credit card debt, but their baLances went down. The average credit card baLance in twenty and twenty was sixty one hundred dollars. By the end of twenty, twenty two IT was twenty seven hundred dollars.

The amount of leveraged that the median family has fell to a twenty year low over the past three years, and the ability families to stay current on their financial obligations is much greater than IT was a decade ago. Much of that is due to lower real interest rates and lower namal rates. So if there's a fundamental change to hire, interest rates mortgagees at eight percent, car payments seven, eight hundred dollars a month, or is IT just become almost unaffordable for many people?

That puts households in a much more precarious financial situation, helps us savers because we can learn more, but IT hurts. Barware makes them more difficult to service. They're dead. IT means that as individuals, as household, we need to be more cognizant of those tradeoffs. Great to meet a mortgage of three percent, to be more careful than mortgage rates are eight percent.

What can we do now though? We don't know the long term trend for real rates of interests down over hundred two years, but we've hit an inflection point where now rates, rates are at two and a half percent. There are sound arguments for why they could stay in that two and a half to three percent range for a decade or more, but we don't know.

It's a function of supplying demand. How much will companies and governments want to borrow and how much will savers want to land by buying bonds versus spending IT to buy goods and services? We don't know, but we do know.

Well, rita, now last week I purchased is part of the U. S. Treasury auction, a five year treasury inflation protection security. This is an inflation index bond. We have a whole guide on our website, a link to that discusses how tips work.

The real yield from the auction was just under two and half percent, about two point four percent, very, very attractive because now I can lock in a five year, two point four percent return plus whatever inflation is. And you still can and you can go to your broker and buy this bond in the secondary market. That's what's on offer right now.

We can lock in a higher yield for seven years, for example, by buying the investor bullet shares, twenty thirty corporate bond tf, the ticker is B, S, C, U. The yellow maturity is over six percent. That's not as risk free as tips, but it's still very tractive because this is investment grade bonds.

So the default ate would be very, very low over time. And then because it's bullet shares is just like holding an indian visual ban, you you hold IT to maturity and you get back that principle. And so you're not subject to interest at risk.

Those fluctuates. And that's the benefit of holding an individual tips or all holding. A bullets share etf. In fact, last week, our plus episode for premium members of money for the rest of us, we did a whole episode on the new tips, bullet shares and compare that to investing in individual tips.

So I do agree, in the current environment, there are a lot of options right now to lock in much higher interest rates without taking much risk. We discuss them last week with little more risk with hail bonds, leveraged loans, lower rist. This week, we discussed tips, investment grade bonds.

And so as a saver, been a pretty, pretty good period means we don't have to take as much risk in the stock market as we we've discussed. We know what the Price of money is today, and we can make decisions accordingly rather than trying to predict. IT is very helpful to understand today's market temperature, but also to put IT in to historical context.

And the reality is the higher interest rates today bucks the trend of a long downward left in interest rates in real rates. We'll see, but we know where things are today, so invest wisely but pick up some yal because we can. That's episode four, fifty three.

Thanks for listening. I have loved teaching you about investing on this podcast for over nine years. Some topics though I just Better explained in writing or with a chart.

And that's why we have a weekly free email newsletter to insider guide. In that newsletter, I share charts, graphs and other materials that can help you Better understand investing. It's some of the most important writing I do each week. I spent a couple hours on that newsletter on wednesday morning as I tried to share something that will be helpful to you. If you're not on the list, please subscribe, go to money for the rest of us dot com to subscribe to the free insiders guide weekly email news letter everything i've shared with you in this episode ment for general education have not considered, your specific risk situation, have not provided investment advice, this is simply general education on money investing in the economy. Have a great week.