You know you’ve got a lot of balls in the air when you welcome plane travel as an opportunity to get things done with minimal interruptions. On my latest flight I eavesdropped on a conversation concerning what will happen with interest rates, and yes, I’m an occasional eavesdropper during my travels. The range of human experiences and perspectives endlessly fascinates me. But I digress… I believe that rates will ultimately rise, however exactly when they will rise is impossible to predict given that the market now responds dramatically to the words of policiticans. When the words and/or deeds of just one person can can induce wild swings, a stable or predictable market is impossible.
First, what does an interest rate mean? Interest is what a lender charges for having to wait to consume. I can consume today or next year. If I wait until next year to consume, I’ve given up consuming today. To get me to sacrifice consuming today, which is of higher value than having to wait a year, I must be compensated. My mom will attest to this given the lengths she had to go to in hiding my birthday and Christmas presents. Now the question is how much? If prices are expected to remain flat, I would be satisfied with, for example, 5% to compensate me for waiting. If prices are expected to increase, then I have to be compensated additionally since I still want my 5% compensation for waiting. If prices are expected to increase 3% in the next year, in order for me to still get my 5%, I must be paid 8% since my purchasing power has been decreased through inflation. I’ve simplified this a bit for purposes of thisÂ discussion because the interest rate also reflects my perception of the likelihood that I’ll actually get paid back. If I think there’s a chance I might not get paid back, I’ll want to charge more. In the interest of brevity and focus, I’m ignoring that factor.
So what could make prices increase over time? An increase in the money supply will cause prices to rise over time.
Think of a simple economy in which there are only two things one can purchase, apples and oranges. This simple economy currently has just $100 as its total money supply.
Number of Apples = A
Price of an Apple = PA
Number of Oranges = O
Price of an Orange = PO
(A x PA) + (O x PO) = $100
If a helicopter flew over our little island, dropped an additional $50 onto the island and the number of apples and oranges doesn’t increase
(A x PA) + (O x PO) = $150
Since A and O remain constant, PA and/or PO must increase.
Since the Fed stopped publishing M3 in March of 2006, it is difficult to identify with any precision an increase in the end money supply, but with bank reserves exploding to unprecedented levels through TARP and “quantitative easing” money printing,the end money supply is bound to increase significantly. This future expectation puts upward pressure on input prices.
This increase in expectations can be seen in the PPI (Producer Price Index) numbers relative to CPI (Consumer Price Index). The chart below shows how PPI has lead CPI consistently throughout 2010. Producers typically cannot immediately push increased costs onto consumers but, eventually these costs will have to be pushed on to the consumer as producers cannot indefinitely absorb additional costs. This will result in increased consumer prices. As we already discussed, when prices are expected to increase over time, interest rates naturally must rise in order to preserve a real rate of return.
The increase in the money supply, or at least the expectations of an increase in the money supply also has an impact on the exchange rate for the dollar. When the supply of US dollars increases, or is expected to increase, it results in currency debasement, meaning the dollar lowers in value relative to other currencies. The majority of US debt is funded by foreigner nations and corporations. In addition, our trade deficit is only made possible through a capital account surplus. We buy more from the rest of the world than we sell to them (capital outflow). This is funded by the rest of the world investing back into the United States more than the US invests outside its borders, this is the capital account surplus (capital inflow). The abundance of foreign debt holders and investors in the US economy places additional interest rate pressures on us as the exchange rate changes. (Please note that the United States has considerably more foreign investment that most other countries. We have long been considered the strongest and most transparent economy, which has led investors to believe that we are a better place to invest than their other options.) If the dollar is expected to decline in value vs. a foreign currency, lenders who primarily operate in that currency will require a higher rate of return on their investment in order to make up for the loss due to currency debasement. For example, if a Swiss lender is willing to purchase U.S. Treasuries at 4% with the dollar expected to remain unchanged relative to the Swiss Franc they will require at least 7% rate of return if the dollar is expected to depreciate by 3% relative to the Franc in order to achieve that same 4% rate of return in their native currency.
This currency debasement will also increase the cost of imports, which means higher prices for consumers and here we go with rising consumer costs. As consumer prices increase, inflation expectations increase and lenders demand a higher nominal rate of return to preserve their real rate of return.
And finally, and this is a more minor point, exceptional events don’t last forever. We are at all time historically low interest rates. There is no clear reason for interest rates to have permanently shifted lower, thus interest rates must rise to get back to historic norms. What can’t last forever won’t. When TIPS have a negative yield, pay attention!
What does this mean for investors? With an expectation of rising interest rates, it would be prudent to lock in a low long-term rate for any longer term debt, such as a mortgage. An increase in interest rates will also mean pain in the bond market. If rates rise, prices for bonds issued at today’s low interest rates will drop. Inflation and higher interest rates historically have also pushed the stock market higher in nominal terms and have corresponded to a rally in the commodities markets.
As I mentioned earlier, with such active attempts to manipulate our economy, it is impossible to predict future trends with any degree of certainty, but if you bet on deflation and instead we get rising interest rates and you have an adjustable rate mortgage, it could get ugly. A higher level of uncertainty reigns than ever before, so all investing and financing should be implemented with a strongly defensive position.