4/14/14 – What Happens When Interest Rates Rise? Part 1: The Natural Interest Rate

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 14, 2014 12:30:00 PM

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I admit I was waiting to see what the markets did before I wrote this post, but now that things seem to be bouncing back, we can move away from worries about stocks and back to worries about bonds. All worries, all the time—that’s the Eeyore channel! (For those who don’t know, I’ve been called Eeyore occasionally because of what some perceived as a dour outlook. I’ve certainly been more cheerful recently, at least about the economy.)

On a more serious note, John Thayer submitted a question that’s been on many people’s minds: “What happens to preferred stocks, MLPs, bonds, etc. when interest rates are finally allowed to go back to their natural level?” It’s an excellent, increasingly timely question, one that will affect everyone who holds these securities—which is to say everyone.

In fact, it consists of several sub-questions that need to be addressed separately:

  1. What is the natural level of interest rates?
  2. What is keeping current rates away from the natural levels?
  3. Will that stop? When?
  4. What happens when it does stop?
  5. What does that mean for our investments?

Let‘s start with question 1. Interest rates are actually the price of money. As such, they change with the balance of supply and demand for money. Unlike with most goods, however, there is a monopoly provider of money that can and does change the supply whenever it wants—the Federal Reserve, or, more generally, the central banks. Interest rates are therefore a market, but a manipulated one.

Even given this manipulation, though, there is such a thing as the natural interest rate, one that balances supply and demand. Economic research has defined it, loosely, as the rate of interest on loans that is neutral with respect to prices, and will not tend to either raise or lower them. (A summary is available here.) This is a vague but useful definition, as it puts interest rates squarely in the Federal Reserve’s current policy preoccupation with deflation.

The Fed’s stimulus policy is directed at lowering rates by injecting money through buying bonds; by basic economics, increasing the supply of money should lower the price (interest rates). This should also act to increase prices, which suggests the lowered rates are below the natural rate, consistent with the definition above.

Depending on how you calculate it, the natural rate of interest comes in around 3 percent. Given the uncertainty inherent in this type of work, that means somewhere between 2 percent and 4 percent. Note that this is a real rate, so we have to add inflation back in, which gives us a nominal natural interest rate of around 4 percent to 6 percent at the moment, based on theory.

Using the Berra theorem, in which the well-known economist Yogi Berra points out that theory and practice are the same in theory but different in practice, we can then compare this to real historical interest rates to see if it makes empirical sense. The chart below shows the rates paid by inflation-adjusted Treasury bonds.

1

The general range, of around 2 percent to 3 percent before the financial crisis, supports the economic arguments and the decline during the crisis. Add 2 percent to 3 percent for inflation, and we’re right back to the 4 percent to 6 percent that economic theory suggests. The lower rates during and since the crisis appear largely due to a “flight to safety,” and therefore seem less indicative of normal rate levels.

Comparing the natural nominal rate of, say, 5 percent with the current rate of around 2.65 percent for the 10-year Treasury bond reveals that, yes, current rates are well below what they “should” be. The Fed has apparently succeeded in its aim to lower rates below the natural level—but it’s not quite that simple, which brings us to question 2. We’ll take a closer look at that tomorrow.

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