Peace is a daily, a weekly, a monthly process, gradually changing opinions, slowly eroding old barriers, quietly building new structures.
John F. Kennedy
Editor’s note: Before beginning this month’s piece, we note that right after last month’s article in which we discussed declining birth rates, the National Review (January 27, 2020) ran a cover story on the “fertility crisis”. It is, no doubt, a topic on which we will hear a lot about in the coming years.
We have discussed the low interest rate environment (and our belief in its persistence) several times in the past few years. Recently, the Bank of England published data showing the trend of real rates in the developed world since the 14th century (Staff Working Paper No. 845). This period covers virtually the entire history of “modern” economies. The data show that despite some upheavals, there has been a steady trend downwards (by about 0.6-1.6 basis points per annum) over that entire period – and imply that we might be entering a period of permanently negative real rates. Given low inflation, this might mean permanently negative nominal rates, a phenomenon that has persisted in Europe already for the better part of a decade now.
Interestingly, just this month the U.S. Treasury issued 30-year Bonds at a yield of only 2.06%, over 10 basis points less than the previous low. These bonds have since traded up in price to yield under 1.70% in the wake of the Coronavirus-scare sell-off in equity markets. To anyone old enough to remember black-and-white TVs, this seems preposterous, but soon these bonds might look like a bargain! There is no general agreement about why rates are so low, but we believe we have some plausible reasons, and our discussions the past few months, particularly about the “end” of global warfare, are very pertinent.
Let’s begin by asking a very basic (but seldom addressed) question: Why do we have interest rates at all? Why should $100 saved be worth, say, $105 in a year [we’re talking “real” rates here, ignoring inflation]? The conventional answer is that the saver has foregone current consumption and is “rewarded” for the delayed satisfaction of spending the $100 by the interest earned. This is not totally convincing upon closer inspection. Someone with money may not be able to consume it all in the present, and even if they could, very well might choose not to simply to save for the future when times might be leaner [“seven years of feast, seven years of famine”], or when they wished to generate less in the present (for example, by retiring). In such cases, there is no “demand” to be compensated for waiting – I am fine with tucking $100 under my mattress knowing it will buy the same amount of food, etc. in a year (when I want it) as it would today. This line of thinking also makes the “normal” upward-sloping yield curve difficult to explain. Why should someone saving for 10 years be compensated more (per year!) than someone saving for 8 years?
The BoE study suggests that savers demand (or have demanded) interest as a form of insurance. They need (or needed) “more” in a future period to compensate for the possibility of loss in the interim. Again, historically, wars and other upheavals (coups, revolutions, plagues, etc.) have made “storing” money a very risky proposition. As we have previously discussed, vast sums in history have been wiped out in these ways. Over the time of the BoE study such events have been becoming rarer and less severe. Not only have devastating wars become almost extinct, stable governments have become the global norm, not the exception. Viewed in this light, rates on high-quality sovereign debt were once a “default premium”, akin to that on a corporate bond today. Now, long-term stable government debt (issued by Japan, the U.K., the European Union, the U.S. and a few others) is truly believed to be default-free (at least up to 50-year time frames or so) and hence demands no risk premium at all. In fact, some might even be willing to “pay” to store their money for future use, leading to negative real rates. Extending JFK’s quote, peace also effects change over decades and centuries and it has quietly built a new regime in interest rates. Next month, we will examine if there are any barriers to just how negative nominal rates can in fact become -- a question that would have been considered ridiculous barely a decade ago, but that is now of some consequence.
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