Thursday, December 14, 2017

Interest Rate Reversals - A Warning from History

There is no doubt that we live in "interesting times" when it comes to global interest rates.  For most of us, the post-Great Recession period of near zero interest rates has been unprecedented and the recent experiments with negative interest rates are a new reality for investors.  While all of this may appear to be a brand new phenomenon, in fact, things are even more interesting when one looks at real interest rates, rates that are corrected for inflation as shown here:

  
A recent posting by Paul Schmelzing on the Bank of England's "Bankunderground" blog looks at the really long term trends in real interest rates and how, by putting the current interest rate environment into a long-term context, we can better understand the relationship between the current low real interest rate environment and the prospect for a return to "normal" interest rates.  To assist with this relationship, the author has looked at seven centuries of data for real risk free interest rates and has produced this graphic:


For your illumination, the source of the risk-free asset data is as follows:

1.) 14th and 15th centuries - sovereign rates in the Italian city states

2.) long-term rates in Spain

3.) long-term rates in the Province of Holland

4.) long-term rates in the United Kingdom after 1703

5.) long-term rates in Germany

6.) long-term rates in the United States

From this data, the all-time real average risk-free rate stands at 4.78 percent and the 200 year average stands at 2.6 percent.  As you can see from the red line on the previous graph, the current rate environment is significantly depressed.

For those of us that have been paying attention to nominal interest rates over recent decades, we've noticed a significant downward trend as shown on this graph showing the yield on ten-year Treasuries:


The author's calculations show a similar trend in real rates over the very long-run as shown on the red line here:


On a constant time trend, the red line shows an average fall in interest rates of about 1.6 basis points per year.

If we take a further look at the multi-century trends, we find that real rates have been depressed below long term averages several times in what are termed "real rate depression cycles".  Here is a graphic showing the nine historical periods of real rate depression plotted by size of interest rate depression versus the duration of that depression:


As you can see here, while the current period of real rate depression is relatively small when measured using the amount of interest rate decline, it is the second longest period of real rate depression over the 700 years in the study.

Lastly, let's look at how these real interest rate depressions reverse themselves:


As you can see, real rates rise very rapidly after they reach their trough, climbing an average of 3.15 percentage points within the first 2 years after the interest rate trough is reached.

A long look back at historical data suggests that the current depressed real interest rate environment is not unique.  While no one can predict the timing, history also shows that real interest rates are  likely to reverse themselves very quickly.  This reversal will have a significant impact on investors, particularly bond investors, who will see the value of their fixed income portfolios "readjust" in what could be a very negative way. 

Let's close with this quote from Alan Greenspan:

"By any measure, real long-term interest rates are much too low and therefore unsustainable...When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.

Caveat emptor.