Inflation is determine by the balance between dollars and good. When there are too many dollars chasing too few goods, inflation rises. In the same way, interest rates are determined by the balance between wealth and growth. When too much wealth is chasing too few investment opportunities the return on investment falls. This is why interest rates have been falling since the 1980s and why interest rates are unlikely to rise much until the global wealth/growth balance is restored.
In this article we explain how interest rates are determine by the supply and demand for credit, and why it will take a large shock to reverse the trends that gave us lower interest rates than the world has seen since the Great Depression of the 1930s.
Bill Gross used this chart in his latest blog post arguing that if yields move higher than 2.60% – a secular bear bond market has begun. His logic is that if the frequently tested “top” of this trend is broken, then the 10-year treasury rate will continue to rise for years to come. We disagree.
The problem with his logic is that it ignores the fundamental reasons why interest rates fell in the first place. As we wrote here, interest rates have been falling for reasons unlikely to reverse anytime soon. Breaking through the “top” of a technical trend line will not reverse rising inequality, high wealth/debt levels, falling productivity, aging populations and other long term trends contributed to the fall in interest rates. These trends have caused credit supply to outpace demand since the 1980s. This is why interest rates fell.
Our key contribution to the extensive literature on this topic is recognizing the role that wealth inequality has played in driving down interest rates, incentivizing excessive debt, and slowing growth. An abundance of wealth, caused by excessive income inequality, driving down interest rates by expanding credit supply since the 1980s. Debt rises because debt is the most common means by which wealth is invested. However, stocks and real estate are also affected as growing wealth drives up prices of all financial assets. This is why interest rates have been falling while stocks and real estate have been trading at higher multiples of earning and rental rates since the 1980s. When interest rates get very low, this incentives poor business decisions and frivolous consumer spending. This leads to slower growth which drives down interest rates even further.
How high will interest rates rise? Not much. We argue that it would take a big shock to reverse the trends that brought interest rates down for the last 35 years. We examine a wide range of potential shocks that could do it: inflation, technological revolution, emerging market boom, government spending, populist uprising and major war. Hence we are not expecting the 10-year treasury rate to break out of the 2-4% range, until the next recession (in which case rates could fall below 2%) or one of the shocks outlined above occurs (in which case rates could rise above 4%).
In section 1, we provide an intuitive theoretical framework to explain the trend in falling interest rates and rising debt levels. In section 2, we support our framework empirically. In section 3, we argue that interest rates will not rise until a large shock reverses the global trends that gave us low interest rates. In section 4, we discuss six shocks that have the potential to bring back higher interest rates as well as our forecast.
1. What drives interest rates
Interest rates represent the “price” of credit. Like all markets, this price is determined by supply and demand. The “supply” of money is the amount of cash that global lenders are willing to lend. The “demand” for money is the amount of cash that global borrowers are willing to borrow. Supply and demand for money is sensitive to the interest rate. Borrowers demand more at lower rates; while lenders supply more at high rates (and vice versa). Picture below is a balanced credit market where the equilibrium interest rate is at price A. Credit markets include the complete spectrum of debt instruments such as sovereign/municipal/corporate bonds, bank loans, and credit cards of all varieties and maturities. However, for this discussion we use the 10-year treasury yield as a proxy for the global price of credit (see box 1).
Global lenders and borrowers include governments, corporations, private companies and individuals. In many cases the same entity can be both a borrower and a lender, such as an individual with both a mortgage and a 401k. In this context, lenders include all entities with savings that are invested in capital markets or deposited in banks; and borrowers include all entities accessing credit markets in order to increase spending.
When circumstances change for borrowers or lenders, demand or supply curves for credit shift to reflect these changes. For example, suppose that suppliers of credit suddenly had twice as much wealth, what would happen? Suppliers would need to invest their additional wealth, so their willingness to supply credit would increase. This means, suppliers are willing to supply more credit at the same interest rate than they were willing to supply before. This is pictured below by the shift from “Supply 1” to “Supply 2” resulting in the equilibrium price and quantity “B”.
Without a commensurate increase in investment opportunities, those demanding credit would still have the same preference (i.e. willing to pay the same schedule of interest rate per dollar borrowed). The outward shift in supply would lead to a drop in price (lower interest rate) and increase in the quantity of credit supplied (more debt). Simply put, interest rates reflect the balance between wealth and growth.
Now that we have a clear picture of what drives interest rates, let’s take a look at why interest rates fell.
2. Why interest rates fell
We have already performed a comprehensive review of “Leading Theories” for why interest rates have been falling since the 1980s. While leading minds disagree on which factors are the most important, nearly all factors seem unlikely to reverse in the near future. Here we will briefly summarize the most compelling theories and show how they affect supply and demand for credit.
- Larry Summers agues in his The Age of Secular Stagnationhypothesis that falling rates are due to an increase in domestic household savings (more supply) and a decrease in business investment (less demand) within industrialized countries. He attributes the increase in household savings to higher risk aversion in response to the Financial Crisis, and uncertainty in the face of the coming Pension Crisis. He attributes lower demand for business investment to our new economy, which he characterizes as more disruptive, with new technologies making long term investments less profitable (ex. Platform Revolution, AI, robotics, cloud computing). Summers argues that interest rates will increase if industrialized countries like the United States stimulate growth through expanded fiscal policy such as investments in infrastructure.
- Ben Bernanke argues in his Savings Glut hypothesis that global oversupply of savings. He describes a situation in which desired saving (more supply) exceeds desired investment (too much wealth chasing too few good investments). Alan Greenspan made remarks to similar effect in 2010 stating, “Whether it was a glut of excess intended saving, or a shortfall of investment intentions, the result was the same: a fall in global real long-term interest rates and their associated capitalization rates. Asset prices, particularly house prices, in nearly two dozen countries accordingly moved dramatically higher.” Bernanke argues that interest rates will increase if global savings drop.
- Ray Dalio argues in his theory on “How the Economic Machine Works” that interest rates fell because the industrialized world is in too much debt. Spending can only come from two sources, cash or credit. Households, businesses and governments across the industrialized world have effectively maxed out the credit cards; which until now have been contributing to economic. As a result, households are saving more (more supply) and spending less (less demand), which in turn makes businesses investment less profitable. Consequently, households and businesses demand more safe assets like US Treasury bonds to invest their savings. Dalio sees many parallels between today and the 1930s when governments and central banks were eventually forced to print money to pay for more fiscal spending. Inflation caused by such actions would cause interest rates to rise.
- Robert Gordonis widely recognized as an expert (if not the expert) on the nature and causes of long term productivity. He points out that productivity has been falling since about 1950. Falling productivity reduces return on investment (lower demand). Businesses only want to borrow if they can make a good return on money invested. Therefore, interest rates will rise once productivity increases. Gordon doesn’t believe that productivity is ever going to rise, hence he thinks that rates will only rise if credit supply falls or inflation rises.
All of these theories point to long terms trends that are consistent with a steady fall in interest rates. Debt has been rising over the same period suggesting that supply has grown faster than demand for credit. While it is hard to say which theory and corresponding factors are more important than others, it is clear that such long term trends are difficult to reverse. For this reason falling interest rates have persisted, despite business cycles, bubbles, Financial Crises, Sovereign Debt Crises, the rise of China, the slowing of Japan and the Asian Tigers, the Internet, and all 28 seasons of The Simpsons.
While we cannot directly observe the supply and demand for credit, we can logically deduce that demand for credit grew slower than supply. This is illustrated by the shifting supply (S) and demand (D) curves above. The equilibrium interest rates are the intersections of these curves which fall directly on the dashed long run downward trend. Fluctuations around the long run trend occur because of short term factors mostly related to the business cycle such as changing inflation expectations, unemployment, economic growth relative to potential (output gap), and risk preference (see Box 2).
Falling inflation can only partially explain the falling rate environment that has persisted since the 1980s. The rising rate environment of the 1960s and 1970s can be largely attributed to inflation scares. Credit supply contracted in nominal terms because investors require returns in real terms. Real interest rates during the 1970s dropped below zero, but the subsequent jump in the early 1980s was mostly due to inflation scares but not some deep rooted supply/demand imbalance. In contrast, the consistent drop post 1980 in nominal interest rates (blue) also coincides with a drop in real rates (green). This provides strong evidence that something bigger and more persistent is driving down interest rates than merely lower inflation expectations. Investors are consistently accepting lower and lower rates of return on investment. [Chart Link]
When talking about long term interest rate trends it is absolutely necessarily to consider global forces. Today’s interconnected world is one big market. Bonds and stocks denominated in different currencies have positive correlations. The more similar the asset, the more investors use arbitrage pricing strategies to profit from diverging prices. We focus on the United States for brevity, but falling interest rates, increasing debt levels, income inequality, slowing population growth, rising asset prices, and other long term trends we discuss are characteristics of the industrialized world (which accounts for most of the global GDP) more generally. [Chart Link]
Rising Supply of Credit (Debt and Inequality)
Leading theories on why interest rates fall point to increased savings which increased credit supply. But most Americans have less than $1,000 in savings so it’s not the working class causing this abundance of savings.
Interest rates started falling at the same time income inequality began to rise. This is not a coincidence. As income inequality grew so did the accumulation of wealth. As wealth grew so did the supply of money. Because nearly all wealth is invested in financial markets such as stocks, bonds, real estate, or private equity, the return on investment in these markets slowly fell. This is why suppliers of money have been willing to accept lower and lower real interest rates on US treasuries.
Many reasons likely contributed to the rise in inequality. Tax cuts for the wealthy are one, most notably the Reagan tax cuts of 1981 and 1986 (bottom left). These tax cuts occurred at nearly the exact same time as inequality began to rise. This increase in after tax income (a flow) should logically increase wealth (a stock) over time leading to greater and greater credit supply. Technology is likely to be another contributing factor. As Tylor Cowen explains in, “Average is Over”, the labor market is becoming bifurcated. Substitutes to computers are losing jobs while compliments are getting raises (bottom right). We evaluated some of these technological changes in our article, “Why Growth Fell”. The trouble with pinning it on technology is that we have had disruptive technological innovations before so blaming it all on technology seems a bit far-fetched.
Inequality and debt levels move together because they are two sides of the same coin. Income inequality necessarily leads to wealth accumulation because the wealthy don’t spend as much of their income. They then invest these savings. Of all the financial asset classes the largest, by far, is the bond market. This is why income inequality has moved with debt levels. But the same pattern is visible across all financial assets, not just bonds. Household wealth to income has been growing on average since the 1980s as well. That’s because growing global wealth has been bidding up the price of all financial assets. Incidentally, this is also the principal reason why Robert Shiller’s Cyclically Adjusted Price to Earnings Ratio (CAPE) has been well above its historic average since 1990. Those expecting CAPE to revert to its mean shouldn’t hold their breath. We don’t expect this to happen until about the same time that interest rates rise substantially.
Falling Demand for Credit (Aging population and productivity)
Leading theories on why interest rates fall also point to the aging population and falling productivity which decrease credit demand. We examined these phenomena already in our article, “Why Growth Fell”, so we won’t go into detail here. Suffice to say that until we colonize Mars global population growth will slow. This is causing the population to age which leads to a smaller work force making it harder for the economy to grow per capita (i.e. labor productivity falls). Some other reasons why productivity is falling include the high cost of quality education, income inequality, and debt burdens. When growth slows, there are fewer opportunities for businesses to expand, thus reducing demand for credit.
The Inequality Cycle
You may have noticed by now that the reasons why interest rates fell are interconnected. We can’t explain why interest rates fell without bringing up income inequality, rising debt, and their influence on economic growth. That is why the team at IntuitEcon created an intuitive framework for putting it all together. We call it “The Inequality Cycle”. It explains how high inequality leads to higher inequality by weakening the economy. This model builds on existing theories for why interest rates fell.
Economic growth is primarily the result of investment in human capital, innovation, and knowledge. This is the gist of “Endogenous Growth Theory”; the best model economists have so far to explain why economies grow. To fund investment we need savings. To get savings we need some portion of society to make more money than they spend. This is why it’s perfectly normal (and in fact quite necessary) for a healthy economy to have some income inequality. Income inequality leads to wealth accumulation which is needed to fund investment.
A healthy economy needs some scarcity of wealth. Some scarcity is good because it allows suppliers of credit to be picky. Being picky means choosing mostly good investments characterized by a high return-to-risk ratio. This makes for an “efficient allocation of capital”; which is a fancy phrase economists use to mean that “money is not spent on stupid stuff”. When money is not spent on stupid stuff the economy is stronger. Scarcity of wealth pushes up interest rates which prevents consumers and businesses from borrowing without a good reason. This prevents excessive debt levels (i.e. leverage) which in turn reduces the severity of business cycles. Higher interest rates incentivize smart business investments because dumb investments become more expensive. Smarter business investments beget more productive companies which beget higher wages and more confident consumers.
When an economy has an abundance of wealth, suppliers of credit can’t be picky. This results in many bad investments receiving funding along with the good ones. Investors are forced to accept lower interest payments, because alternative investments such as real estate and stocks have also become overpriced, reducing return on investment, due to too much wealth chasing after too few good investment opportunities. Many Borrowers are happy because their borrowing cost is low, but they are not entirely exempt from the consequences either. When consumers and businesses can borrow at very low interest rates, they can afford to buy things and invest in projects that add little value. Insolvent businesses borrow more money to survive instead of going bankrupt. Poor business investment reduces labor productivity which in turn puts downward pressure on wages. Lower wages will eventually lead to less consumption because growth of debt can’t exceed the growth of income in the long term. Consumers rack up debt using cheap credit because their stagnant wages can’t keep up with the bills. These all lead to slower economic growth which in turn reduced demand for credit. The only reason why debt is still rising is because (as we can observe empirically) the increase in credit supply outweighs the decrease in credit demand leading to the equilibrium C.
This brings us, full circle, back to inequality. Falling interest rates due to too much wealth chasing too few good investments lead to higher priced financial assets. Bond prices rise as a direct consequence of falling interest rates. Stocks trade at increasingly higher multiples to earnings. Real estate prices rise to increasingly higher multiples of rental rates. All financial asset prices rise together because they are all substitute means of storing an increasing amount of global wealth. This price appreciation in financial assets is great for the wealthy. For everyone else it means a higher cost of living and meager interest on what little savings they have in the bank. Stagnant wages also hurt the working class more than the wealthy because the wealthy get a disproportionate amount of their income from their growing investments. That is how high inequality leads to higher inequality.
And that…is the “Inequality Cycle”.
The Inequality Cycle was developed by the IntuitEcon team. We drew from several theories that touch on these concepts which we reference in our articles, “Why Interest Rates Fell”, “Why Growth Fell”, and “How the Economic Machine Works”. We were also inspired by the movie, “Inequality for All”, by Robert Reich, an outspoken economist who served as Labor Secretary under President Clinton. Our main contribution is in drawing the connection between rising inequality, falling interest rates, and rising debt levels.
3. How high will interest rates rise?
Answering this question is hard, because we have only one precedent for today’s low interest rate environment….the 1930s. Extrapolating from historical patterns is fraught with misinterpretation. The world is constantly changing, but some things never change, such as the law of supply and demand. The 1930s were characterized by ultra-high debt and income inequality levels that bear a striking resemblance to today.
We are not the first to notice this. Ray Dalio, the founder of Bridgewater, has said that comparisons to the 1930s helped him see the Financial Crisis coming and develop his “long term debt cycle” theory which we discuss here. He argues that the industrialized world is in a prolonged period of deleveraging like what industrialized countries experienced during the Great Depression.
How long? This is impossible to say, but by definition the end is characterized by significantly lower debt levels and higher interest rates. After the Financial Crisis, global debt growth didn’t drop, it accelerated. The last time the world was in a long term debt cycle it lasted from 1929 through 1945, but given the massive consequences of WWII it’s hard to say what relevance this 16 year timeline has for today.
The Great Depression could have gone on for many more years if it wasn’t for WWII. Higher debt levels persisted long after the crash in 1929 despite the “New Deal” and extreme measures by central banks. In 1937 the US experienced a major setback. Like today, interest rates in 1937 had fallen to zero and stimulative monetary policy fueled a rally in asset prices. In 1937, the Federal Reserve tightened monetary policy prematurely resulting in a stock market crash and lower home values (the Fed has started tightening, but knock on wood…no crash yet). This drop in the value of assets crippled economic growth in a manner similar to 1929 as households responded to their drop in wealth by increasing their savings setting in motion a vicious cycle of higher unemployment, falling asset prices, and even more need to save.
WWII forced a massive fiscal stimulus as the government “employed” millions in the armed forces. Businesses were forced to improve productivity. Politicians were forced to work effectively. The GI Bill ushered in a new age of higher education. How long would the Great Depression have lasted if WWII had not necessitated these fundamental improvements? Could we have exited the Great Depression era of low interest rates, slow growth, and massive debt without a major shock, or is necessity the true mother of invention?
Given the magnitude and persistence of the forces that have been driving interest rates lower since the 1980s, we think it would take a pretty big shock before we see interest rates rise persistently. We discuss the types of shocks that could shake us out of The Inequality Cycle in our conclusion.
In order to predict when interest rates will rise one first needs to understand why interest rates fell. We reviewed all the leading theories here. What we found is that while leading minds don’t all emphasize the same reasons, all point to a rising supply of credit, and some point to falling demand. This is consistent with interest rate and debt trends. Supply of credit has grown rapidly while demand has contracted some as growth has slowed. We illustrate this here for the United States, but as we showed earlier; the industrialized world has experienced rising debt and falling interest rates since the 1980s.
Leading theories to explain this point to many causal factors including global trade imbalances, aging population, income inequality, the pension crisis, global instability, high debt levels, and a 65 year trend of falling productivity. While it is hard to say which factors are the most important, it is clear that such long term trends are difficult to reverse. For this reason falling interest rates have persisted, despite business cycles, bubbles, Financial Crises, Sovereign Debt Crises, the rise of China, the slowing of Japan and the Asian Tigers, the Internet, and other major changes over the past 30+ years.
Basically, what all these theories boil down to is an imbalance between wealth and economic growth. Wealth has been growing because of rising income inequality. Growth has been slowing because of aging populations and falling productivity. High inequality also hurts growth because of what we term the “Inequality Cycle”. In the Inequality Cycle, the abundance of wealth that comes with high inequality leads to poor investment decisions incentivized by cheap credit. This is why interest rates fell while and debt levels rose. Both were are driven by a growing abundance of wealth chasing too few financial assets. This is why the prices of all financial assets, not just bonds, have been increasing since the 1980s.
For interest rates to persistently rise the way they have persistently fallen since the 1980s, the balance between global wealth and growth needs to be restored. It would take a pretty big shock to reverse this trend, because as we described earlier, these trends are self-reinforcing. Many trends like the aging population will continue to slow growth in just about any conceivable scenario. That is why we believe low interest rates are here to stay until some major shock persistently decreases the supply of credit (which is closely tied to global wealth) or increases economic growth. Here are six shocks that could do it:
- Inflation – Inflation fears can cause interest rates to rise rapidly as suppliers of credit require real returns. Economists call this a negative supply shock. A good recipe for inflation is massive government spending just when labor markets tighten. This is why Janet Yellen voiced concerns with Trump’s trillion dollar spending plan. In order for inflation to lead to sustained higher interest rates things would need to get way out of hand. However, when you factor in a potential trade war between the US and its trading partners, Brexit, and the possibility of a Euro breakup…inflation fears start to seem more credible. Of the six shocks we think could lead to sustained higher interest rates, we consider this one to be the most likely.
- Technological revolution – One optimistic scenario for rising interest rates would be a new technological revolution leading to acceleration in labor productivity and economic growth. This positive demand shock would increase incentives to borrow by creating valuable investment opportunities. In our article, “Why Growth Fell”, we investigate this scenario, but didn’t find the evidence compelling. New technologies like the internet, smartphones and GPS have greatly improved our quality of life, but have not done much to increase the economic pie. To the contrary, technology might even be hurting economic growth by displacing manufacturing and other labor intensive sectors faster than our labor markets can handle. For these reasons (and others discussed here), we are skeptical that a technological revolution will lead to booming economic growth and with it higher interest rates…but it’s possible.
- Emerging market boom – Many emerging market economies are overdue for some catchup growth. This scenario comes from the economic theory of convergence where it is assumed that less developed countries are more likely to experience rapid growth because they can more easily adopt the lessons learned from developed countries. Like a technological revolution, this is another positive demand shock China’s rise since the 1990s is a good example having risen from $314 GDP per capita in 1990 to over $8,000 today. Of course, the rise in emerging market growth would need to be much bigger than this. Interest rates continued to fall during China’s rise despite it having the largest population in the world at 1.36 Billion. The combined populations of India (1.25B), Brazil (200M), and Russia (1.43M); which make up the rest of the BRIC countries, have a combined population of not that much more than China. Thus, even if they experienced a similar sustained “catchup” growth as China since the 1990s, it probably would not be enough to offset the forces that drove interest rates down since the 1980s. For these reasons we are skeptical that growth could accelerate in enough emerging markets to sustainably push up interest rates, but it could happen.
- Government spending – Governments of large economies are big enough to at least temporarily push up interest rates. If the United States moves forward with a massive spending bill that would constitute a positive demand shock scenario. However, such a shock would likely be short lived. Large economies have used deficit spending to bolster their economies since Keynes first popularized the strategy in the 1930s. However, interest rates have continued to fall across the industrialized world despite the largest run up in global government debt in history since 1980. Large deficit spending in concert with a tight labor market could create inflation. This would most certainly increase interest rates, but only temporarily. For governments to cause a sustained increase in interest rates they would need to implement policies that could significantly increase global economic growth. Economists rarely agree on anything, but nearly all agree that higher economic growth can be achieved by reducing barriers to free trade and labor mobility. Unfortunately, we are more likely to see the opposite as we discussed in our article, “Euro Conundrum”. For these reasons we don’t see the governments of the largest economies causing a sustained increase in interest rates…but it could happen.
- Populist uprising – A populist uprising that results in more wealth redistribution could lead to higher interest rates. Any significant reduction in wealth would create a negative supply shock. Whether such wealth redistribution is good or bad is not the point. The point is that over time this could reduce the amount of money available to lend. There are many ways this could happen with higher income taxes and estate taxes on the wealthy being the most obvious examples. Populist movements have already started gaining momentum in Europe as we wrote about here. The surprising popularity of Bernie Sanders during the United States presidential election provides another useful data point. For these reasons, we find this scenario more likely than those discussed so far, but probably not likely in the near future.
- Major War – This depressing scenario would almost certainly increase interest rates. By necessity, WWII caused the largest economic growth acceleration in US history. This massive positive demand shock pulled the US out of the Great Depression and ended the ultra-low interest rates of the 1930s. Much of the wealth and infrastructure of Europe was destroyed. Recall that wealth destruction creates a negative supply shock. Rebuilding Europe soaked up a big chunk of the world’s capital and got many European back to work resulting in a positive demand shock. WWII was clearly a horrific tragedy and we do not mean to sound insensitive by discussing it in the context of interest rates. We bring it up because it illustrates just how huge shocks have to be to sustainably alter the path of credit markets. Of all the decades in the past century, the 1930s provide the best comparison to the economic environment we have today. Like today, the 1930s were characterized by ultra-low interest rates, huge debts, sluggish growth and high inequality. No one knows how long it would have taken to break free from the Great Depression if WWII had never happened. We are not going to venture a guess on the likelihood of a major war, but the Fourth Turning theory provides compelling reasons to believe that the odds are higher over the next decade than any previous decade since WWII.
All of these shocks are unlikely to happen any time soon. For this reason we don’t see the 10-year making a sustained rise. However, we also don’t see how interest rates could continue to fall. Much of the industrialized world has already hit or fallen below the zero “lower bound”. There are practical limits to negative rates. In Europe and Japan those limits have likely already been reached. Therefore, the bull market for bonds is already over.
So if interest rates are unlikely to rise or fall…where do they go?
We expect the 10-year treasury to stay below 3% until the central banks in Europe (ECB) or Japan (BOJ) signal an end to their quantitative easing programs. This was the level that the 10-year hit after the Taper Tantrum. At that point we expect the 10-year to stay below 4%. We chose 4% because that was the level of the 10-year before the Financial Crisis and subsequent quantitative easing (QE) programs. When the next recession inevitably comes we anticipate the 10-year falling below its prior low of 1.3%.
Feel free to share your own thoughts on when interest rates will rise. There is no better compliment you can give us than your thoughtful criticism. You can reach us at email@example.com, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.