Interest Rates

There is much talk among investors and financial experts alike that interest rates in the United States cannot fall any lower and therefore in the near term they must rise.  I find this analysis flawed on many fronts and will dig into the theories below but there is a high probability, much higher than most people or experts realize, that the low interest environment could be here to stay for years to come.

The main comparison that is used is Japan.  Japan has been dealing with low interest rates for decades and there is no sign that interest rates will rise any time soon.  The country has been stuck in a deflationary spiral for decades with a brief respite from mid-2006 to the end of 2009 but deflation has once again reared its ugly head. 

There have been plenty of theories revolving around why Japan could not exit this spiral.  One issue was that monetary conditions were held too tight for too long.  Once monetary conditions loosened the velocity of money was almost zero so no matter how much money was pumped into the economy the problems continued to persist. 

Another issue was unfavorable demographics.  Japan had and still has a very large aging population.  Typically an aging population is offloading assets rather than purchasing more.  This constant selling of assets particularly housing and investments can create a drag on these prices until the pendulum swings to a new generation that can absorb everything that the elder generation has to offload.

Additionally there were a couple of bubbles that burst almost simultaneously.  The equity market collapsed dragging down the real estate market.  Both of these occurred within years of each other mainly because the assets were intertwined as cross collateral.  This deflationary pressure from asset prices collapsing formed the next issue which was weak and insolvent companies.  A lot of these entities were propped up by the ability to raise additional cash from the equity and real estate markets.  After the collapse they were kept afloat for a while by banks that had investments in these companies in the hopes that things would turn before they had to write the loans and investment off. Furthermore there was an inherent structural flaw in that a lot of the companies employed people for life meaning that no matter how much red ink the company bled, lay-offs were not on the table.

As the property market went so did the banks.  Many were insolvent years before they were finally left to fail.  This lead to an all out fear of investing in banks and undermined any confidence in the financial system.  Savers moved their cash into government bonds and out of the banking system keeping government interest rates low.

Finally deflation was imported from the rest of the world.  Countries such as India and China flooded the market with cheap goods fueling the inflationary spiral even further.

Turning to the United States today there are a number of parallels.  The housing and labor markets continue to be weak.  As much money as the Federal Reserve is pumping into the economy there has not been any significant benefit other than stock prices.  Stop the printing and the market will roll over as we have seen recently. 

In my view most US banks are insolvent and are only kept afloat by the accounting regulations that do not require the banks to mark their loan portfolios to market.  The US demographics are skewed towards the aging baby boomer population and the overhang from the underfunded Medicare and social security programs will continue to drain government cash for decades to come.

So the question is why will the US be any different from Japan.  There are a number of differences.  The first one is that the United States still maintains its position as the reserve currency of the globe.  While I see this changing in the future I do not see it happening any time soon.  This status allows the United States more leeway in terms of money printing than any other country in the globe.  This money is showing up in inflationary pressures around the globe and will ultimately pressure the inflation rate that the Federal Reserve follows.  This could force the Federal Reserve to increase interest rates to stave off inflation.

The second difference is that Japan was and is a creditor nation.  The United States is the debtor nation to the globe.  At some point the United States will have to pay its debts back.  Whether this is done in a controlled fashion or whether it is forced upon the Treasury is still in question.  If it is forced on the Treasury you could see a massive spike in interest rates as they try to find enough buyers for the debt.  In order to attract buyers in an uncontrolled environment interest rates have to rise and this could force the government's hand.

My assessment of the situation is that while consensus is that rates will have to rise soon I believe that there is more than a fair chance that low interest rates will be around for years to come.  There may be the odd spike in interest rates, but with the level of skepticism that abounds and the fact that the baby boomer generation wants a safe return for what is left of their retirement, any spike in say the 10-year note will be met with ferocious buying that places a cap on just how high interest rates will go.  So while there may be an argument for higher interest rates do not be surprised to see these levels remain in place for the foreseeable future.

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