We often hear about the Fed and interest rates. But what do they really mean to me? Matt and Seena are joined by AB’s senior research associate, Chris Brigham, as they discuss the history of rates and their influence on our everyday lives.
00:00 - 00:31
Interest rates are at the lowest level in history, and that has some people scared. Will this be the cause of the next big bubble or is there a rational reason for the persistence of these low rates? We'll find out today on The Pulse. Hi, everybody, I'm Seena Ghaznavi and welcome to The Pulse, where we cover trends in the economy, markets, and asset allocation for long- term investors. Joining me today as always Matt Palazzolo.
00:31 - 00:50
And we have a new person today, Chris Brigham's senior research associate here at AB. Matt, it's usually just you and I and we have another person here. Is there something you want to tell me? No, nothing at all. Chris is one of our team members. Chris and I have worked a lot together over the last number of months looking at interest rates, which is our topic today.
00:50 - 01:00
And you guys wrote a paper actually on this as well that's on www.Bernstein.com. Interesting times. That's right. Thanks for the shameless plug. But yes, 15-page paper that's on www.Bernstein.com right on that front page.
01:01 - 01:34
And what we do, and we'll talk about a little bit today, we look back at the history of interest rates to try to understand the drivers, but more importantly, look forward to try and make some determination about where interest rates are likely to go and for what reason. So I shouldn't be jealous that Chris is here. No, not at all. OK, Chris, welcome to the show. Thank you. So let's start off with just a very high level and extraordinarily important question for, especially for a guy like me who has a mortgage. What is the point of interest rates? Why do we care? Yeah, why do they matter? Yeah, but you're absolutely right. Mortgage is a really good example, right.
01:34 - 02:08
For anybody that owns a home or has financed anything. When I say finance, I mean borrowed and then you have to pay somebody back because they gave you the money. In the interim, there's a cost to that. Nobody's going give you money for free because you're not riskless. Seena, I know you, you really are not risk free. Very not riskless. Right. So but there's a cost to borrowing and that is what interest rates are. It's the cost of capital over a certain period of time. The government borrows money for a long period of time. You and I borrow money. It has to do with credit cards. It has to do with homes. Anything that can be financed has to have a cost to it.
02:09 - 02:21
Chris, in your research, and I'm very excited to hear how far back we're actually going to go on this question, where did the notion of interest rates actually come from? So we're going to go all the way back. We're going to go back before money.
02:21 - 02:47
If you actually look at the ancient times, the first loans were actually of cattle and of grain. So they predated money in any way, shape, or form. And if you kind of come a little bit closer to the present, go to the medieval ages or.... Wait, so people were charging interest on cattle and grain, what was the interest? Oh, you would have to repay another cow at the end of the year. So extra cow at the end. Yeah. Or that batch of your season's crops.
02:47 - 03:16
OK, so we move forward. So we fast forward a little bit, go through a little bit of actual recorded history and get to the Medieval ages and get to the Renaissance. And there were a lot of more modern financial lenders back then who had a habit of lending both to merchants and to princes. And back then, we're used to sovereign nations being the ultimate credit and the modern economy. But back then, merchants were a lot more creditworthy than princes because they had businesses, versus princes that just had land.
03:16 - 03:41
And then when they died, nobody could actually get any money from them. So there was no real value in being a prince, is that you're saying? Not really, no. And so actually, there are a lot of really bad loans made to those people. So, Philip the Fair of France actually borrowed a bunch of money and he banished bankers, cancelled his debts, and then he burned his bankers at the stake. They were the Knights Templar. So he burned them all at the stake. Over a debt? Over a debt.
03:41 - 04:15
Well, maybe some other things. I got to pay my student loans. OK, well, then moving forward. Yeah. So coming forward from there, you know, we've obviously come a lot further in time and, you know, post Renaissance, I think finance became a lot more effective. You started to actually have nation states arise with real borrowing capacity and that and the evolution of finance have kind of brought us to the era that we have today, where the staples of modern finance are these sovereign bonds of the United States, of Germany, of Japan.
04:15 - 04:35
And those are the ultimate credits in the world that we live in today. So that's not necessarily a modern phenomenon, but at least the last few centuries. That is amazing. And I think we should do an entire podcast series on interest rates in the pre- monetary times. But Matt, back to you. That's all well and good and that's the history.
04:35 - 05:03
But what influences the change in interest rates over time? Right. There's always a lot of factors that influence movements in interest rates. Right. We watch it on television. We look at it in the paper. But some of those factors that influence interest rates are cyclical, like pace of economic growth. Inflation is a big one. Some of them are secular. You can think about the supply and demand for capital, which is really where Chris and I spent a lot of our time researching is that supply and demand for capital. Just like anything,
05:04 - 05:20
if you look at the supply and demand for oil or grains or iron ore, you have more supply of something, the price of it comes down. You have more demand for something, the price of it likely goes up. Got it. So why don't we talk about some of those secular factors that you brought up?
05:20 - 05:43
Yeah, so again, supply and demand for capital, that gets at these secular issues. Supply, when we're talking about money and interest rates, supply is equivalent to savings and demand is equivalent to the desire to invest in something, invest in some project, invest in yourself, Seena, for your student loans. And as that relationship between those two things change, so does the cost of interest rates or the cost of money.
05:43 - 05:56
So back to your original question about the secular drivers, secular drivers over the last number of decades, really over the last four decades, go back to the early 1980s, put downward pressure on interest rates. Right.
05:56 - 06:24
Interest rates topped out at about 15 percent in 1981. Today, the 10-year Treasury yield is 1.7. So they've fallen a lot over time, in large part not just because of inflation, which was meaningful, but in large part because those secular factors like the budget deficit, which worked a little bit differently, but demographics, income inequality, and monopoly power have all influenced rates in a downward way, putting downward pressure on rates.
06:24 - 06:51
Can I pick one that we dial in a little bit and zoom in on? Absolutely. Choose one of that list. Demographics. OK, I was kind of hoping you were going to say demographics, because I think it's so interesting. There's so many different facets of demographics. But two facets of demographics that I think are the most tangible for our listeners would be first, life expectancies and fertility rates. Those two have changed a lot over the last couple of decades and as such and by extension, have influenced interest rates.
06:51 - 07:09
So life expectancies first. For decades, the life expectancies in the United States have increased. For example, life expectancies in the United States in 1955, Seena, were roughly 70 years. So at birth, the expected life expectancy for somebody was 70 years.
07:09 - 07:41
Now they're roughly 80 years for the broad population and for those individuals who are wealthier in our population, it's even longer. At the end of this century, so at the end of the 2000s, life expectancies across the United States are expected to be closer to 90 years at birth. So you can see there's been an elongation of life expectancies. And so these rising life expectancies have pushed interest rates down because in general, people choose to save more for their longer lives.
07:41 - 08:10
Right. Like you expect to live longer. You don't want to run out of money, so you save more, and more savings equals more supply. And in that, the supply/demand relationship, all else being equal, If you have more supply of something, then the price of it falls. Now, fertility rates is, that is something different, right. That works a little bit differently underneath that umbrella of of demographics. Fertility rates... But let me let me just interrupt you real quick, just to make sure that I understand it and our audience understands it.
08:10 - 08:29
So we're living longer, which means more money gets to accumulate in our accounts in the form of savings. We're also probably working longer. So we're generating more income over time to save. And if we're living longer, that means there's more money supply in the market, which will drive interest rates down. if there's less money, then interest rates would go up.
08:29 - 08:54
That's right. If I'm only thinking I'm going to live to the age of 60 and I'm working until like 55, then I don't have to save all that much. But if I'm working to 65 or 70 and I'm going to live until 80 or 85, then I need to save a lot more, so that money goes into the bank, it goes into investments and that's just money out there, which increases supply.
08:54 - 09:16
Demand stays the same. The price of that capital comes down. And you're saying at the end of the 2000s, we're only going to be living to 90 years old. What I was expecting 900. Well, you may be, but again, that's across the broad population. If you look at the subset that is wealthier, has access to healthcare and high quality healthcare, it's likely longer than that. Yeah. And so let's go to, you
09:16 - 09:51
brought up the point of fertility rates now, so let's go to that. Yes. So fertility rates have been falling in the United States since the 1950s, right. In 1955, again, just to pick a point in time, fertility rates were about three births per woman. Now they're just under two. Right. So birth rates have, fertility rates have come down over the last several decades. And that matters a lot to the cost of capital because lower fertility rates increase what we call and what the industry calls the capital to labor ratio in the economy.
09:51 - 09:51
09:51 - 10:18
What does that mean? Yeah, right. So that the capital to labor ratio is essentially, let me give you an example. I think that makes it the most, the most tangible. Imagine, Seena you operate, I don't know, a bakery in a small town and you're the only employee, and you've got five ovens and you're producing at full capacity. And there's plenty of demand for your bread and everybody loves your bread. And if only you had another oven, you could
10:18 - 10:40
produce more bread and sell more, because there's plenty of demand for it, but unfortunately you live in a small town and there's no other additional labor in your town and nobody else to operate that oven. And so as a result, there's no value in you going out and having another oven. And so you're not going to borrow at the bank to get that other oven.
10:40 - 11:07
And so with that, there's less demand for capital because there's less labor in your population, in your town. And so with that, with with that lower labor, there's less demand and interest rates come down. Is there an argument to be made that with technology increasing and allowing us to do more... What if I had an oven that was very optimized technologically and I didn't really need another person?
11:07 - 11:32
How does that get factored in? Yes, absolutely. We think about this and we wrote about this in the paper related to monopoly power. If you think about companies that are technology companies that have built up capabilities over time, they can do a lot more with less today relative to decades ago. And with that, that has also brought down demand for capital and as such, brought down interest rates. Absolutely. So that's just also one factor that's bringing it down.
11:32 - 11:51
But labor, no matter what, if we have fewer people, that's just going to... there's no need for that other oven. And it's an oversimplified example. But that just gives you the case that labor, that capital to labor ratio changes depending on, you know, even if there's demand, depending on how many people you have. OK, and I'll have to be a gluten free bakery as well.
11:52 - 12:26
So I'd say one other thing to keep in mind is that people are a little worried because interest rates are really low right now. But it's not the first time in history that interest rates have been low. Really good point. So if you look back, interest rates in the 1600s, late 1600s... So here we go again. Oh, yeah. So we're going to walk you through it. So interest rates in the late 1600s were also extremely low. So high-quality borrowers back then were borrowing at 1.75 to 2 percent, which is basically what the US government is borrowing for today. If you fast forward about 100 years from there, another big bond bull market, this time in England, late 1800s, you're borrowing at around 2 percent,
12:26 - 12:54
if you were a high-quality borrower. Fast forward 100 years to the US. You're also borrowing at about 3 percent back then and then you had kind of a multi-decade bear market from the late 1890s through the early 1920s, a bond bull market from the 20s through the 40s, and then the big bear market and the hyperinflation that culminated in the 70s and then the most recent, my entire lifetime bull market in bonds, that's lasted since 1981 till today.
12:55 - 13:26
And everybody has been expecting it to end since 2003. But we're still going. For those listeners, we know how old Chris is now. But I want to just point out one thing. You mentioned all those historic examples of low interest rates and obviously the world has changed so much in that time. But let's go back to the one I think you said the 20s to the 40s. That's like we're talking 40s is in post-World War II as well, right? Yeah. So I think, you know, if you look at the world in the 30s and 40s was a little bit crazy.
13:27 - 13:51
Obviusly. We had the depression, we had World War Two. If you kind of look at what came out of World War II, the world and the environment you had then was actually similar in some ways to what we're seeing right now. So World War II, we're financing a war effort. We're issuing a lot of bonds. The Fed is capping rates by buying bonds. It's actually funny. There was an article in the Wall Street Journal a few days ago, the feds actually thinking about capping the rates on bonds again if we go into a recession.
13:51 - 14:18
So they're literally going to try to pull out the playbook that they haven't used since 1947. But back then, you had kind of the closest thing that you've seen to an actual bond bubble in the history of the United States, or really probably the history of the world, where people were actually actively buying bonds, buying sovereign debt for the capital gains. They were, they thought that the Treasury wasn't going to have to issue bonds ever again after the war. And so there was the fear that the supply was just going to go away.
14:18 - 14:35
And this was your last chance to get on board and get these rates while you could. That gave way over the course of multiple decades to a slow and steady rise in rates. And then ultimately, things got a little bit out of hand. You know, the good times, the good times rolled a bit too far.
14:35 - 15:09
And the government borrowing actually wasn't such a big issue for quite a while in there, but then ultimately, you had the increasing deficits, and then that all culminated in the inflation of the 70s and the bond bear market that we saw in which Paul Volcker ultimately put an end to by hiking rates in the 80s. OK, so that kind of brings us to today somewhat, right, we're, went through the 80s and now we're kind of into this low interest rate period today. And, Matt, I want to turn back to you now to talk about another kind of factor that influences interest rates, and that's income inequality.
15:09 - 15:30
Yeah. So tell me a little bit about that. How does that actually impact what decisions are made around interest rates? Yeah, Seena, you and I have talked about income inequality and populism a number of times on the show. You wouldn't normally think that income inequality, which is front page news often enough over the last couple of years, has an influence on interest rates. But it absolutely does.
15:30 - 15:37
You know, Chris and I have done a lot of the work, and I think, it's clear, first of all, if we look at some of the numbers, they're staggering.
15:37 - 16:05
If you look at the period from the late 1980s to today, the top 1 percent of the population has seen their net worth grow by seven times, while the bottom 50 percent has only seen their net worth grow by two and a half times. So like a staggering, and we've got a display in the paper, that shows that staggering gap between those two cohorts. That has so many ramifications that we've seen in recent years, political and otherwise.
16:05 - 16:28
But in that list of ramifications, you can absolutely include interest rates because, you know, the rich or that top one percent have a higher propensity to save each incremental dollar that they have. And as incomes are skewed more towards them, it puts upward pressure on savings and pushes down the level of interest rates. That's that connection to interest rates.
16:29 - 16:45
Thing is that, that's not all. The effect is then magnified because the rich just by definition have more money. And so their higher savings rate is applied to a larger dollar value, which gives it a disproportionate impact on national savings.
16:45 - 17:04
And so undoubtedly, Seena, again, you and I have talked about this, but inequality will drive our politics and the economic rules of the game for a really long time to come. And so, as Chris and I started to think about the future, not the past, but the future and whether or not income inequality will continue to play a role, we had to think through
17:04 - 17:37
how will politics, if at all, close that gap between those cohorts. And if that's the case, well, then maybe we'll start to see somewhat of an upward pressure on interest rates as that gap closes, as inequality narrows. But if politics is not successful, if there's not an effort to close that gap, then we might continue to see what we've seen for such a long time, which is, again, the rich with a larger share of the savings, saving more and more, more supply of capital brings down interest rates or at least keeps them down.
17:38 - 17:44
OK, Matt, we've covered a lot of ground, but let's just bring everything back to where we are today. Where are interest rates today? Yeah.
17:44 - 18:09
So on our way to the studio today to 10-year Treasury yield, just as a number 1 benchmark, was at 1.7 percent. So the United States Treasury can basically borrow for 10 years at a 1.7 percent annual interest rate. Transparency here, recording this on the 28th of January, so things could, things could always change. And so what does this low rate mean for Americans in everyday life and our clients? What does that mean for them every day?
18:09 - 18:36
Yeah, well, again, borrowing costs are low relative to history. So that's a good thing for anybody that wants to borrow. Again, I keep coming back to the student loans. If somebody has student loans that are struck at that low rate, that's a low rate, again, relative to history, for someone that wants to borrow for a long period of time. Somebody needs to borrow for a home, to get a mortgage, provided you can put down the down payment and all of that. It's a low interest rate relative to where it's been historically.
18:36 - 19:00
Many of our listeners remember getting a 15 percent mortgage back in the 1980s. Those days are gone. Right. We're all borrowing at three, four percent today and so forth. Whatever you want to borrow for, a credit card, car loan, and so forth, interest rates are low. Yeah. And I would say, the other side of that is that low interest rates aren't always good. So for people who are trying to save for retirement, for people who are in retirement, low interest rates are not a problem.
19:00 - 19:19
But they are definitely an issue. You know, it's a lot harder to put away your money when bonds are yielding less than 2 percent than it is to do that when bonds are yielding 5 percent. And it's a lot harder to live off of the income on a portfolio of bonds when they're yielding less than 2 percent, than it is when they're yielding 5.
19:19 - 19:50
So that makes it tough for a lot of our clients. And, you know, we live our days in the market. So I think we probably focus on this more than most people. But like, it is just, it is a challenge. And for our clients and for other people who are planning for retirement and who are in retirement, there are some good ways to deal with this and there are some bad ways to deal with this. One way that people tend to deal with this is to stretch for yield, to take on too much risk and not get compensated for that risk. And that's a really, really bad strategy.
19:50 - 20:17
So, you know, one thing that is important to remember is that there's no right silver bullet for every single person out there. You really need to sit down with your financial advisor and you really need to think about what's the right strategy for you. These are challenging times to deal with in the markets, not just for portfolio managers, but also for just people trying to, you know, to save for retirement and live their lives. And you're right, it is a more complex period of time that we're in, which means we have to be a lot more vigilant in how we're doing.
20:17 - 20:28
You can't just set it and forget it. So what's the role of the Fed? They've got a big job. I mean, you know, they're hearing it from every which way. There's a lot of stakeholders involved here that want something to happen.
20:28 - 20:29
So what do they do?
20:29 - 20:58
The Federal Reserve controls the short-term interest rates here in the United States, and they're trying to balance employment levels. They're trying to balance inflation. Those are their two mandates. They want to keep both of those at a comfortable level. Their objective for inflation is something around 2 percent. They want to get to "full employment," whatever that means. And unemployment today in the United States is down at 3.5 percent, which there too, speaking of decade long records, we're at a 50-year low on unemployment here in the United States.
20:58 - 21:16
So the Fed certainly plays a really, really important role of also influencing and having an impact on the cost of capital at the short end. And then the market influences and the supply and demand, which we've been talking about the whole show, influences interest rates that are further out. But the Fed, we have to watch closely as investors.
21:16 - 21:51
And I think it's important to note that the Fed is kind of trying to solve for what that equilibrium rate in the market is. So there are those pressures pushing up on rates and pushing down on rates. All the secular drivers that Matt said, and that's going to move where that equilibrium rate the Fed needs to hit and they'll adjust it a little bit to deal with the cycle. But that rate itself is out of their hands. So as much as people want to blame the Fed, they're really just trying to, like, track that rate. And that's a challenge because the only way they can see the effects of where they're setting rates is with a lag.
21:51 - 22:25
So it's a little bit like navigating on a rainy night in the dark with a flashlight that doesn't look that far out. They're really just kind of feeling their way along. And that's a tough job. Thank you for that answer. And I think what we also want to look towards, because at the top of the show, this podcast is for long-term investors. What is our long-term outlook on this stuff, Matt? Yeah, so I'll come to the conclusion that we drew in that paper. You're not going to start at 1600s? No. I'll start with the executive summary, which basically says that based on those secular factors,
22:25 - 22:57
right, and it's largely the budget deficit as we look out over the next 10 years, it's the demographics, both here in the United States and globally, it's issues like income inequality, monopoly power, which we touched on a little bit. If you look at all of those, which, again, historically have had a meaningful influence on pushing rates down to where we are today, we're talking about real rates. So net of inflation. If we look at where those are likely to go over the next 10 years, it's our conclusion that there's a mixed bag on all of them. Right.
22:57 - 23:04
Some will have put upward pressure on interest rates. Some will keep a ceiling or a cap on interest rates. So it's our expectation for that.
23:04 - 23:35
For the next 10 years, real interest rates are likely to stay right around where they are at these low levels. And then only after a 10-year period do we start to see more of an upward pressure on all those issues and in particular, the budget deficit relative to GDP pushing up interest rates along with the other factors around demographics and otherwise, only then do we see an upward move in interest rates, but for the next 10 years, we probably stay where we are today again on real interest rates net of inflation.
23:36 - 23:45
I think we have to stop it there. This was super informative for me and I know it will be for our audience as well. Chris, will you promise to come back? Oh, yeah.
23:45 - 24:10
I'll give you an education on, you know, the history of God only knows what next time. That will be great. And thank you all for listening. If you'd like to learn more, please see the link to our February Capital Markets Outlook blog. Why are interest rates so low and where might they go, in this episode's description. And if you enjoyed this episode and haven't subscribed to our podcast yet, please go to the iTunes store, Google Play, or wherever you listen to podcasts to subscribe and rate us.
24:10 - 24:28
Also, please e-mail us with your thoughts, questions, and feedback to insights@Bernstein.com and be sure to find us on Twitter at BernsteinPWM. Bernstein: Making money meaningful for individuals, families, and foundations for over 50 years. Visit us at Bernstein.com.
- Matthew D. Palazzolo
- Senior Investment Strategist—National Director, Investment Insights