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Low Interest Rates Here To Stay?
Old 02-08-2005, 07:33 PM   #1
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Low Interest Rates Here To Stay?

Greg Ip of the WSJ published an article in the Feb.7 edition which should be of some interest to ERs, ER wannabees, and future Rs (like me). The Page 2 article is entitled Low Interest Rates May Be The New Norm.

He examines the curious current state of low long term rates. The current 10 year Treasury Bond rate is hovering around 4%. Wall Street consensus is that will increase to 5.2% a year hence.

Wall Street fundamental case for higher long term rates: U.S. economy is strengthening; fear of deflation has evaporated; Fed raising short term rates on a measured pace; and, the twin deficits are getting larger. Why has the long end stayed so low? Wall Street says temporary factors including higher demand for bonds by underfunded pension plans, reduced supply from mortgage markets, the carry trade, and, Asian Central bank Treasury buys to prop up local currencies vs the dollar.

Alternative minority view: Long term rates are composed of two components an inflation premium combined with a real rate of return. Inflation expectations have been permanently reduced. Inflation is low and going to stay there for years to come. Since 1997 inflation fluctuating between 2% and 2.5%. Inflation premium set at 2% to 2.5%. It is the real rate of return that has declined. Real rate of return used to be between 3% and 4%. Today is about 1.7%. Argument is that bond yields are now at their historic average since 1831. That is the norm. The 1980s and 1990s high yield days were abnormal and not likely to return. Low LT rates are at the historic norm and are here to stay. Sustainable in the long term.

Implications of minority view: Markets will be less volatile. Investors more willing to buy longer term riskier assets. House prices remain at nosebleed altitudes, current stock valuations are sustainable over the long run. A prolonged capital investment cycle yields high profits from growing sales and inexpensive capital. Woo Hoo!

Party Pooper view: Low yields are really suggesting that the profit outlook is de minimus everywhere in the world. Corps are not spending on cap projects. Corps hoarding cash. increasing dividend payouts and buying back stock. Old bugaboo still holds-- inadequate aggregate global demand. Inadequate saving in US but massive saving overseas. US savings rate 1% Chinese savings rate 40%. World awash in savings and a lot of it winds up in US bond markets. But, LT rates cant stay low in relation to Feds policy of measured ST rate hikes. Despite a world awash in liquidity, dollar devaluation and slower productivity growth will push inflation higher forcing Fed to move faster with, presumably , even higher short term rates. In other words, current LT rate situation in US is not sustainable.

Questions for the board

Who's right here?

Is it possible we can be looking at a world of low (nearly no) yields on financial assets as far as the eye can see in a world of improving economic conditions, robust GDP growth, expanded trade, higher profits, and low inflation?. A world in which everybody gets healthy except the investor/lender? A booming worldwide economy with meager investment returns over the long run due to massive savings /worldwide liquidity resulting from miserable aggregate global demand? A world of low, low, low investor capitalization rates. ie., vanishing real rates of return falling into a black hole of oceans of surplus capital? (1.7% and going, going, going, gone?) Sure helps explain the current wacko market cap of the S&P 500, but how long can this situation of virtually giving your capital away for nothing persist? Is this combination of economic circumstances at all rational and sustainable over the long haul? What does all this imply for the prospects of FIRE for those of us who are going to depend upon the returns from financial assets down the line?

No offense to anybody. Just asking the question is all.

Donner
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Re: Low Interest Rates Here To Stay?
Old 02-08-2005, 08:25 PM   #2
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Re: Low Interest Rates Here To Stay?

Who was it that said he needed "a one handed
economist" Harry Truman?

I don't think the economic cycle has been repealed.
When the economy heats up too much the gov will
cut money supply and visa versa. Rates will follow,
and the beat goes on ....... IMHO

Cheers,

Charlie



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Re: Low Interest Rates Here To Stay?
Old 02-09-2005, 03:30 AM   #3
 
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Re: Low Interest Rates Here To Stay?

Hello Donner! Excellent post!

Assuming low interest rates are "here to stay", then
I guess I did the right thing by building a bond ladder
with no bottom rungs . I will likely be dead before
a lot of my stuff matures. Of course, the implications of
your questions/musings are huge for all ERs;
unanswerable but huge nonetheless. In my case, I have decided to "stay the course" with my long term bonds. I thought it over carefully before I went there.
No one really knows what will happen, and perhaps
most important to me my fixed investments are throwing off income which looks to be adequate for us
for a very long time (one year and 7 months to SS).
That said, if everything goes to hell (high interest rates
and high inflation) I believe I still have options and
back up plans to prevent most ER disasters. In the end,
that's about the best you can do. The rest is in the hands of the gods and the politicians

JG

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Re: Low Interest Rates Here To Stay?
Old 02-09-2005, 05:26 AM   #4
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Re: Low Interest Rates Here To Stay?

Rates will be lower than in the recent past as Baby Boomers retire. They will desire more bonds to stabilize incomes in retirement.
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Re: Low Interest Rates Here To Stay?
Old 02-09-2005, 07:13 PM   #5
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Re: Low Interest Rates Here To Stay?

I read the article yesterday, too. It was just one more piece of evidence that you never can assume you 'know' which way a market is headed. Lots of fixed income experts had their heads handed to them over the last year.

One thing to always focus in on with interest rates is real vs nominal. Nominal interest rates may well go up, because inflation will probably heat up. But real interest rates may not move much. I believe that current real interest rates are pretty much right in line with their historical trends -- it was juicy real rates during the last 20 years that everyone is responding to now, thinking today's rates are somehow low.

There is a massive amount of capital out there, and lots of people are cottoning onto the joys of being a creditor. Not sure where all this will end up, but I wouldn't be surprised if we faced a long period of relatively low real rates.
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Re: Low Interest Rates Here To Stay?
Old 02-09-2005, 08:20 PM   #6
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Re: Low Interest Rates Here To Stay?

Low rates are here to stay?

Yes!

No!

Yes again.

Yes...yes...yes...yes (harry met sally moment, I know)...no...no..yes...YES...YESSS!!...no.

Maybe.
Maybe.

I guess the point is, they probably arent, but they might be for a while.

Time heals all wounds, and as my favorite person Bill Thomas once said, wounds all heals.

Wait for it...
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Re: Low Interest Rates Here To Stay?
Old 02-10-2005, 03:33 PM   #7
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Re: Low Interest Rates Here To Stay?

Well guys, Im pretty much scratching my head over this one, too. I note that the 10 year bond closed under 4% on Ash Wednesday. This in the face of recent quarter % hike in the Fed Funds Rate. 2.5% overnight money vs less than 4% 10 year money. Hmmm? Makes you wonder if somebody knows something we don't know.

Richard E. Cripps, chief market strategist for Legg Mason is quoted in the Washington Times today and his view about summarizes it for me:

Why are we seeing strength in bonds here? It could be the bond market is anticipating a period of slower economic growth going forward, which could mean earnings estimates may be too optimistic, and need to be adjusted lower. It just raises more questions. It raises more uncertainty. It's not what you would expect with the Fed raising interest rates. I think that disconnect is troubling to some stock investors.

I confess, I do get a bit twitchy when things are not what you would expect.

I have a couple of dark random thoughts about this. I'll share one with you:

Dark Random Thought No 1

I have gotten used to the idea that American workers and wages have got to adjust to Chinese coolie wage levels. About a billion Chinese hands, backs and minds are willing to work, and are low bidding to get the work, on just about anything you can think of.
William Greider in his book One World Ready or Not: The Manic Logic of Global Capitalism has a chapter entitled "Same Work Same Pay". Message: You Americans want to do the same work that Chinese coolies can do? You get the same pay as Chinese coolies. (average monthly wage of a Chinese manufacturing worker? -- $14 per month!) BTW, a great easy to read book with real life stories from a round the world journey that Greider took to examine the impact and direction of the global economy. In true ER spirit, you can get it for two bucks used at Amazon or free in your local library!

What I haven't gotten my mind around yet, but I guess I better start getting used to, is the notion that my RETIREMENT CAPITAL is going to have to compete long term, probably over the life of my retirement, with COOLIE CAPITAL. And the principle which we are so accustomed to with respect to industrial wages fully translates to the wages of capital. The factors of production -- labor and capital are more fungible than we imagine. Think of it this way--- you got maybe a whole village of Chinese Coolies who work 12 or 14 hours a day for six or seven days a week for slave wages. Out of those slave wages, they consume next to nothing and save 40%. Along comes Donner with his TSP retirement stash who goes to Wall Street and says : Boys I will let my retirement capital go to work for you in return for a little inflation premium of about 2.5% and a nice little modest real rate of return of, oh, say, 4%, for a nominal 6.5%. We got a deal? And the Boys reply? Not so fast Donner, we got a whole village of Chinese/Indian/Vietnamese/Japanese/Indonesian/Korean wage slave coolies in the next room with an old rice basket full of capital equal to your TSP retirement stash. And they tell us they will put their capital to work for a lot less than any wages your retirement capital will work for. Sorry, Donner-- Same Work Same Pay! You get slave wages for your Retirement Capital! Take it or leave it!

Hence, the vanishing real rate of return? Maybe a part of the reason.

Now, I know this is a dark thought which most of the ER community on this board is loath to contemplate. Lower, maybe a lot lower, returns on our retirement capital going forward is a little scary to think about. Would put a crimp in our retirement lifestyle. But if the world is changing around us, and the old comfortable ways of thinking about things don't seem to be explaining what is happening on the ground, don't you think we ought to start questioning the existing conventional wisdom?

Am I going to be run off this Board for spreading subversive, negative, scary thoughts?

I'd share Dark Random Thought No 2 with you but then I surely would be run off and probably this very evening!

So, enough of this for now.

Donner
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Re: Low Interest Rates Here To Stay?
Old 02-10-2005, 03:54 PM   #8
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Re: Low Interest Rates Here To Stay?

Quote:
average monthly wage of a Chinese manufacturing worker? *-- $14 per month!
So I'll just take $4,200 to China and live on my 4% SWR.
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Re: Low Interest Rates Here To Stay?
Old 02-10-2005, 04:09 PM   #9
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Re: Low Interest Rates Here To Stay?

Quote:
So I'll just take $4,200 to China and live on my 4% SWR.
Not sure you could really call that "living". :-/
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Re: Low Interest Rates Here To Stay?
Old 02-10-2005, 07:07 PM   #10
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Re: Low Interest Rates Here To Stay?

[quote]

Donner: Very uplifting. (I thought Vincent Price had died )

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Re: Low Interest Rates Here To Stay?
Old 02-10-2005, 07:47 PM   #11
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Re: Low Interest Rates Here To Stay?

Donner,
I am all for dark thoughts -- as long as they are informed ones. As a business owner I always wanted to know 'the worst that can happen' and once I had mentally prepared for it, I could relax.

One quibble, I think your $14/month figure for Chinese labor is way low -- I visited there 20 years ago and $40/month was considered very low then. (also, Coolie might be considered a perjorative term now-- Chinese people are increasingly coming to school here, flying back and forth, starting companies, and looking very much like any American, in fact lots of them are Americans!)

But your point is, I think, that it's a new world. I put my capital to work in China and other places like it, in large part because that is where it will work the hardest in the years ahead, I think. In 1913, I read today, English investors had 1/3 of their capital invested abroad, a lot of it in developing economies like the United States. My Portfolio is now also 1/3 overseas. I say don't get attached to anything, move with the flow, let your capital do what capital has always been supposed to do: work hard creating value, where it is needed the most. (If our capital works hard, then we won't have to!)
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Re: Low Interest Rates Here To Stay?
Old 02-11-2005, 07:49 AM   #12
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Re: Low Interest Rates Here To Stay?

Quote:
fungible
I love that word. I used it recently in a report (I mentioned fungible employees) for an IT assessment I conducted a few months ago. Their office manager circled the word on the draft report and wrote- "wrong word, we're not related to fungi." I just smiled and left the word in the final report.
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Re: Low Interest Rates Here To Stay?
Old 02-11-2005, 08:07 AM   #13
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Re: Low Interest Rates Here To Stay?

Quote:
One quibble, I think your $14/month figure for Chinese labor is way low -- I visited there 20 years ago and $40/month was considered very low then. *(also, Coolie might be considered a perjorative term now-- Chinese people are increasingly coming to school here, flying back and forth, starting companies, and looking very much like any American, in fact lots of them are Americans!)
I have a Chinese housemate actually, and from all accounts, the Chinese kids are learning to consume just like the west. Those little emperors have been pampered all their lives by their parents, and the same sense of entitlement will continue through their adult lives. Visa has entered the Chinese scene offering the Chinese a way to buy today, and pay tomorrow... the American way! The traditional Chinese aversion to debt is diminishing. Watch for a growing demand for a rapid increase in the quality of life from the upcoming generation- a demand for increased wages from the educated workers, and an increase in consumption.
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Re: Low Interest Rates Here To Stay?
Old 02-11-2005, 08:49 AM   #14
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Re: Low Interest Rates Here To Stay?

Quote:

I love that word. I used it recently in a report (I mentioned fungible employees) for an IT assessment I conducted a few months ago. Their office manager circled the word on the draft report and wrote- "wrong word, we're not related to fungi." I just smiled and left the word in the final report.
Its not as good as "Nuance".
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Re: Low Interest Rates Here To Stay?
Old 02-11-2005, 12:53 PM   #15
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Re: Low Interest Rates Here To Stay?

Quote:

Visa has entered the Chinese scene offering the Chinese a way to buy today, and pay tomorrow... the American way! The traditional Chinese aversion to debt is diminishing.
I'm assuming that right now the Chinese are net creditors, we are the debtors. But if what you are noticing takes root, and they start getting the hang of borrowing (at a personal level, perhaps fuelling even more borrowing at the business level) then China could become net debtors, too. That seems like it would do great things for those of us in the business of renting out our capital!

btw, Gong Hay Fat Choy! to all our Chinese members on the Board. (Chinese New Year was Wednesday for all us 'roundeyes' on the Board who might not know).
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Re: Low Interest Rates Here To Stay?
Old 02-11-2005, 05:16 PM   #16
 
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Re: Low Interest Rates Here To Stay?

Donner,

Good topic and interesting analysis. My own view, however, is that you don't need to look outside our own borders (United States) to find the reason for low interest rates going forward. I've always been a fan of "supply and demand" and babyboomer economics. When the babyboomers were first graduating from college, interest rates rose, in part I believe because there was a glut of boomers interested in loans to finance automobiles, stereos, homes, etc. Shortly, this same glut of boomers will shift from net borrowers to net lenders as they phase into retirement and manage their nesteggs. I suspect that as a simple matter of supply and demand the balance will then favor borrowers and interest rates will be suppressed. Perhaps an overly simplistic view of things, but I still suspect demographics could play an inportant role in keeping interest rates low.
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Re: Low Interest Rates Here To Stay?
Old 02-12-2005, 04:19 PM   #17
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Re: Low Interest Rates Here To Stay?

ESRBob--

My desk dictionary defines the term coolie this way:

Coolie, n. 1. in the Orient, an unskilled native laborer. 2. a person doing heavy labor for little pay, especially one transported from the Orient.

This is the way I intended the reference. A person doing heavy labor for little pay. The point I was trying to make is that our retirement capital may be compelled to do heavy labor for little pay for some time to come.

I guess what I am really trying to do is gin up an argument for a combination of robust economic growth going forward for a long time to come together with permanently low long term interest rates. A kind of Oriental supply side theory of capital surplus leading to happy days ahead for the economy. The alternative minority view in Geg IP's WSJ article. Good news for the economy but not so good for ERs living off the interest.

But I'm not sure I have convinced myself. I am leaning toward Charlie's thinking -- they haven't repealed the business cycle yet.

Annette Thau has a pretty good Bond primer in this month's AAII Journal entitled: Bond Market Strategies for a Rising Rate Environment. She makes no predictions on the future course of LT rates. In fact, claims that it is essentially an unknowable. Urges defensive strategy to survive no matter which way rates go. (diversify, diversify, diversify). But she makes some good points -- i.e., consensus is usually wrong when it comes to interest rates.

Thau points out that the yield curve is still normal in that it is upward sloping. But it sure appears to be flattening out. And, she makes some cogent points about inverted yield curves:

"Inverted yield curves typically occur toward the end of a series of rate increases by the Federal Reserve. Why? Because successive rate increases create the expectation that the economy will slow, and that future inflation will be low. Inverted yield curves are said to predict recessions.....Where will long-term rates go in 2005? The answer is no one knows. The yield curve could continue to flatten -- that is, short term rates could rise while long-term rates remain the same. Or long-term rates might rise, but much more slowly than short-term rates. Another possibility is that the yield curve might invert somewhere down the line, if the economy were to turn sluggish again. But that is not a prediction."

To me, what's happening with these LT rates is the most interesting thing going on in the markets these days. There is a message here for those sharp enough to interpret it. If Charlie is right, and the old rules still apply, then a flattening out yield curve is the canary in the mine shaft for this economic cycle. What happens after the Feds next meeting will be pretty critical IMHO. If they raise another quarter and 10 year Treasuries don't budge from the 4% level that would not be a good sign for the economy. That would not be a good sign at all. If they don't raise at the next meeting that also will not be a good sign for the economy. I think the equity markets are going to have to see some spurt in the LT rates to assure themselves that Charlie's old rules are still in play and the economy is moving along briskly, thank you very much. This is a case where bad news (rising LT rates) is good news (the economy is on track, friends).

I guess I am with that guy from Legg Mason. This LT rate situation is a bit disconcerting. Not what you would expect in a truly vibrant economy at this stage of recovery. This current rate performance bears with it the faint whiff of an oncoming recession. The longer it persists the stronger the odor will get. LT rates are flashing a yellow warning sign at us right now. If you see the equity markets churning at this level and going nowhere with no significant movement of the LT rates, watch out. If you see continued flattening out of the yield curve, watch out. If you see the yield curve actually invert, that's it, Katy, please bar the door. The equity markets will roll pretty quick if that ever comes to pass IMO. (not anywhere near that at this point but keep your eyes peeled)

So, you can see why I am kinda rooting for those hard working, hard labor, low pay coolies (my kind of people, no disrespect at all meant) to be a new element in economic events to challenge Charlies view that the old rules still apply. Kinda wishing that some new rules are at work. But I really don't think we’re going to be so lucky. We should all breath a little easier if we see LT rates moving up a bit from here.

Donner





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Re: Low Interest Rates Here To Stay?
Old 02-12-2005, 04:22 PM   #18
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Re: Low Interest Rates Here To Stay?

R.H.--

I think your point is right on. I am a case in point.
Very leery of equities at this point. More concerned about capital preservation and earning a decent return.
Probably going to be milions like me in not too distant future. Demographics is destiny.

Donner
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Re: Low Interest Rates Here To Stay?
Old 02-13-2005, 08:28 AM   #19
 
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Re: Low Interest Rates Here To Stay?

Quote:
Shortly, this same glut of boomers will shift from net borrowers to net lenders as they phase into retirement and manage their nesteggs. I suspect that as a simple matter of supply and demand the balance will then favor borrowers and interest rates will be suppressed. Perhaps an overly simplistic view of things, but I still suspect demographics could play an inportant role in keeping interest rates low.
R.H.

Most Boomers don't have any liquid assets to lend. They will keep working and not retire in the numbers forecast. And this is another reason that Social Security is not the 'crisis' currently being Spun.

I can't remember who said this - "There are two groups of people in regards to forecasting interest rates. Those who claim that they don't know - And those that don't know that they don't know."
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Re: Low Interest Rates Here To Stay?
Old 02-13-2005, 12:42 PM   #20
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Re: Low Interest Rates Here To Stay?

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ESRBob--


Annette Thau ... points out that the yield curve is still normal in that it is upward sloping. But it sure appears to be flattening out. And, she makes some cogent points about inverted yield curves:

"Inverted yield curves typically occur toward the end of a series of rate increases by the Federal Reserve. Why? Because successive rate increases create the expectation that the economy will slow, and that future inflation will be low. Inverted yield curves are said to predict recessions.....
Donner, thx for pulling out this information from AAII -i- I should probably re-subscribe...,

Have never thought much about inverted yield curves, but your quotes hit me like a ton of bricks... an inverted yield curve would be the perfect way to punish all those people holding short term bonds while rewarding or at least not punishing the contrarians holding longer maturities. I'd been thinking short tem bonds couldn't be _that_ bad to hold, and would certainly not tank in price as much as longer maturities, so like everybody else have been holding more than my share of them. Now I see that fed tightening could deliver capital losses to the short term bondholders, and the inverted yield curve would leave the longer end scott free. Sort of an "aha moment'.

Though I must say that Penfed 5yr 5% APY CD with modest penalty for early withdrawal looks like a pretty good solution for holding at least some of the safe 'short term' money.
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