Powerful forces keep U.S. interest rates low

There are really two questions here. First, where are U.S. interest rates likely to head over the long-term and, secondly, why have they been dropping?

The first question is fairly easy to answer. Many financial market participants realize that interest rates are likely to head higher over time. The problem arises in your definition of time.

We at Chantico Advisors tend to discount the accuracy of short-term forecasts (or predictions) as we are not traders in the true sense of the word. Interest rates continue to stay in a range of historic lows, despite daily and weekly volatility.

If you look at the history of interest rates on the 10-year Treasury note, the current range of 2.5% – 3.0% is lower than any time since 1960. At some point, interest rates are headed higher. However, we are not in the prediction game and simply do not know when that will happen.

That being said, there are many powerful forces working to keep interest rates low in the US. Let’s take a look at a few.

It has been estimated by the Pew Research Center that 10,000 Americans are retiring every day. These new retirees are likely to become more conservative with their investments and will be seeking ways to generate income from their capital.

The safest way to do that is by buying US government bills, notes and bonds. When demand is high, prices increase and in the bond world, interest rates go down. This is an example of increased demand.

Another example of increased demand has to do with the alternatives available to investors that want to generate safer, government backed income. Spanish 10-year bonds are currently yielding less than the comparable 10-year US Treasury bonds.

The Spanish unemployment rate has hovered around 25% since January of 2012. Would you rather earn more interest in the US with a growing economy or less in Spain with a 25% unemployment rate?

On the supply side, there are also a few factors at work. According the Wall Street Journal banks are holding far more US Treasuries than they have in the past. In fact as of March 31st, US banks held over $237 billion of Treasuries compared to just $31 billion at the end of 2007. Even more impactful is that the Federal Reserve holds over $3 trillion of assets compared to less than $1 trillion before the financial crisis. Increased demand and lower supply leads to higher prices and lower yields.

Finally, there is the political aspect of interest rates (which is not even supposed to be a factor). We don’t suggest that interest rates are manipulated. Yet think about this: If interest rates rose to a more normal level, which has averaged 5.7% on all Treasuries over the past 20 years, 85% of all income tax payments would go to one source: interest on the national debt.

That would leave precious little left for all other federal spending and discussions about “pork barrel” spending would be irrelevant.

When this all turns around, we simply don’t know. We merely react to movement in the markets as they occur and invest client capital accordingly.

Disclaimer: Any investments discussed in this presentation are for illustrative purposes only and there is no assurance that any manager will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Past performance does not guarantee future results.