Interest Rates and US Investors: Don't Be Greedy!!

Mike Smitka
Professor Emeritus, Economics, W&L
Judge, Automotive News PACE Awards

I've now begun posting the occasional article to the financial blog site SeekingAlpha. I'll cross-post portions here. SA gives greater visibility than Blogger, and I even get paid a token amount. I've a couple posts on Tesla, and now one on Interest Rates and US Investors.

The core point is that very low interest rates are here to stay, because not just US growth but global growth is at a very low level, and for all the talk of new technology, appears likely to stay here. The bullet points from the article:

• The latest unemployment data show a continuation of the steady increase in employment since the bottom of the Great Recession in 2010.
• Interest rates show different patterns, with long rates going from low to lower.
• For "value" investors, this poses two dilemmas. One is that low interest rates undermine the utility of discounted cash flow models. Caveat emptor!
• The second is that low long-term rates imply neither growth nor inflation for the foreseeable future. Surely, stock market returns will be similar! Any claim of double-digit returns is too good to be true. Don't be greedy!
• None of this applies if you're a (short term) speculative trader. As an economist, the short-run is "noise" - I can offer no analytic tools to help you.

In the article I note that George Soros, now focused on philanthropy, has moved his fund from macro speculation (cf. his [in]famous bet against the British Pound in 1992. Now he's in it for the long haul, instilling Dawn Fitzgerald as CIO. With a focus now on steady returns for the long haul – a reasonable goal for most personal investors – they're looking at returns of 5% per annum, with years when they'll do worse.

What are current bond returns? One approach is to look at current bond prices, which provide a 6-month yield of 1.58%, a 10-year yield of 1.83% [below the current level of inflation] and a 30-year yield of 2.27%. But another way to look at rates is to look at different rates across time to figure out the implied 1-year yield at different maturities, something I've posted about several times. That gives qualitatively the same picture: a steady secular decline over the past three decades, and (to allow reading individual series) the past 2-odd years. Implied one-year bond rates two decades from now are 2.55% using the most recent data (Monday, 09 Dec 2019).

Now these are nominal rates, which (by definition) are: i = real rate + inflation + risk premium. Unlike equities, US government bonds carry no default risk. At today's very low rates, the risk premium is also small: there's not much chance of bond prices rising [interest rates falling further], plus low rates imply bond prices are already high and can't go much higher. Markets are betting that inflation will remain low as well, and so there won't be much downside. Stocks ought to show a bit better return, the well-known and poorly understood equity premium. But the bottom line remains: unless you engage in speculation, you won't have returns much above 5%. And remember, most people leave casinos poorer.