Wednesday, April 16, 2014
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When Interest Rates Rise

CAMBRIDGE – Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall, and anyone holding them will be hurt. To the extent that banks and other highly leveraged financial institutions hold them, the bursting bubbles could cause bankruptcies and financial-market breakdown.

The very low interest rate on long-term United States Treasury bonds is a clear example of the current mispricing of financial assets. A ten-year Treasury has a nominal interest rate of less than 2%. Because the inflation rate is also about 2%, this implies a negative real interest rate, which is confirmed by the interest rate of -0.6% on ten-year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.

Historically, the real interest rate on ten-year Treasuries has been above 2%; thus, today’s rate is about two percentage points below its historical average. But those historical rates prevailed at times when fiscal deficits and federal government debt were much lower than they are today. With budget deficits that are projected to be 5% of GDP by the end of the coming decade, and a debt/GDP ratio that has roughly doubled in the past five years and is continuing to grow, the real interest rate on Treasuries should be significantly higher than it was in the past.

The reason for today’s unsustainably low long-term rates is not a mystery. The Federal Reserve’s policy of “long-term asset purchases,” also known as “quantitative easing,” has intentionally kept long-term rates low. The Fed is buying Treasury bonds and long-term mortgage-backed securities at a rate of $85 billion a month, equivalent to an annual rate of $1,020 billion. Since that exceeds the size of the government deficit, it implies that private markets do not need to buy any of the newly issued government debt.

The Fed has indicated that it will eventually end its program of long-term asset purchases and allow rates to rise to more normal levels. Although it has not indicated just when rates will rise or how high they will go, the Congressional Budget Office (CBO) projects that the rate on ten-year Treasuries will rise above 5% by 2019 and remain above that level for the next five years.

The interest rates projected by the CBO assume that future inflation will be only 2.2%. If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher.

Investors are buying long-term bonds at the current low interest rates because the interest rate on short-term investments is now close to zero. In other words, buyers are getting an additional 2% current yield in exchange for assuming the risk of holding long-term bonds.

That is likely to be a money-losing strategy unless an investor is sagacious or lucky enough to sell the bond before interest rates rise. If not, the loss in the price of the bond would more than wipe out the extra interest that he earned, even if rates remain unchanged for five years.

Here is how the arithmetic works for an investor who rolls over ten-year bonds for the next five years, thus earning 2% more each year than he would by investing in Treasury bills or bank deposits. Assume that the interest rate on ten-year bonds remains unchanged for the next five years and then rises from 2% to 5%. During those five years, the investor earns an additional 2% each year, for a cumulative gain of 10%. But when the interest rate on a ten-year bond rises to 5%, the bond’s price falls from $100 to $69. The investor loses $31 on the price of the bond, or three times more than he had gained in higher interest payments.

The low interest rate on long-term Treasury bonds has also boosted demand for other long-term assets that promise higher yields, including equities, farm land, high-yield corporate bonds, gold, and real estate. When interest rates rise, the prices of those assets will fall as well.

The Fed has pursued its strategy of low long-term interest rates in the hope of stimulating economic activity. At this point, the extent of the stimulus seems very small, and the risk of financial bubbles is increasingly worrying.

The US is not the only country with very low or negative real long-term interest rates. Germany, Britain, and Japan all have similarly low long rates. And, in each of these countries, it is likely that interest rates will rise during the next few years, imposing losses on holders of long-term bonds and potentially impairing the stability of financial institutions.

Even if the major advanced economies’ current monetary strategies do not lead to rising inflation, we may look back on these years as a time when official policy led to individual losses and overall financial instability.

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  2. CommentedOzgur Ersin

    Prof. Feldstein notes that the low interest rate on long-term Treasury bonds has also boosted demand for other long-term assets...bonds, gold, and real estate. When interest rates rise, the prices of those assets will fall..."
    Considering the financial crisis starting from late 2008 and the monetary policies followed afterwards led to a certain point that the elasticity of money demand approached a so called zero interest rate bound. Further, low interest rates fail to encourage the aggregate demand. However, once the interest rates rise as the effective demand increases; in an environment of increasing sales; this won't damage the demand for real assets. First of, the investors will reevaluate their portfolio balances and diversify between real, financial and monetary assets, while their returns increase, the demand for them willl also increase. Second is, in an environment of expansion, real assets will also be financed through credits demanded by the investors and this would put upward pressure on the interest rates. It should be noted that expansionary fiscal policy with falling price levels might create a wealth effect which would increase interest rates.

  3. CommentedC. Jayant Praharaj

    Mr. Feldstein calculates the long-term real interest rate as the difference between the long-term nominal interest rate and the current inflation rate. But to correctly take into account the effect of inflation, one needs to form expectations about long-term price trends, and not just short-term price trends. Long-term price trends are difficult to predict since it involves central bank commitments to employment and inflation over long time periods, changes in spending behavior and investment behavior in the long run and the difficulty of predicting business cycles. This simplistic calculation can lead to misleading values of the real long-term interest rate. The fact that the TIPS are fetching the price that Mr. Feldstein's calculation suggests probably simply means that the buyers of these securities are using similar simplistic considerations. After ten years, they may not get a real effective annual return of -0.6%, but something entirely different.

  4. CommentedMichael Holt

    Understanding what may happen when interest rates rise may be just as important as the question as to when interest rates may rise. Some dismiss this with glib comments such as:

    "Why should I be concerned if interest rates return to more normal levels by historical standards? We've experienced 6% Treasury bond rates before, so why should I be concerned about a potential return to those levels?"

    There is, of course, no guarantee, that a rise in interest rates would be capped at those levels, but even if rates rose only to those levels, the fact remains that the total amount of debt outstanding is now much, much higher than it was just ten years ago, in both absolute terms and relative to the size of the global economy.

    There has also been a pendulum shift in terms of which countries are burdened with debt. There was a time when the Soviet Union suffered from crushing debt levels, as did many emerging market countries. Today, debt levels in Russia (the Soviet Union no longer exists) expressed as a percentage of their GDP are far lower than those in the US and many developed countries, and the same can be said of many emerging market countries particularly the oil exporting countries.

    A hike in interest rates translating into higher carrying costs on higher levels of indebtedness relative to the levels of yesteryear should therefore be a concern, particularly since it could have a greater adverse impact on what are today the most powerful countries in the world.

  5. CommentedVan Poppel charles

    Professor: you wrote ' the Fed pursued a low long-term interest rate in the hope of stimulating economic activity ... the extent of the stimulus seems very small. Should you imagine that the opening of a spigot of credit at 0% from the Fed can cure the ills of the actual business slump when at the same time the US government applies the principle of sound finance: reducing government expenditure and rising taxes creating as such a negative business sentiment from the economic agents inciting them to reduce also their expenses; saving during a business slump simply increases misery all round; monetary policy should not be given a task for which it is not designed.
    also, when I own a 10 year bond at 2% and when the interest rises till 5% , of course the market value of my bond diminishes, but as a long term investor I do not lose anything when cashing at maturity date.

  6. CommentedNicholas Albicelli

    Potential math error here. At the end of 5 years, the original bond is only a 5 year bond, with a duration of say 4.5 years. So the change in price of the bond is more like 13.5% (= 4.5 * (5 - 2)). Further, if the 10 year is at 5% and the curve is normally sloped upwards, the 5 year might be a little lower, mitigating the price change even more. Assume it's at 4%, then the change in price is only about 9% (= 4.5 * (4-2)).

    Yes there are other offsetting errors that could cause an investor to lose money but the market knows all this and has priced the future increases in rates in pretty well. EMH and all that :)

    1. CommentedMichael Holt

      Correction to the correction: the author stated that the underlying assumption is to rollover ten year bonds every year, not to buy and hold a ten year bond for five years as you've suggested.

    2. CommentedMichael Holt

      Correction to the correction: the author stated that the underlying assumption is to rollover ten year bonds every year, not to buy and hold a ten year bond for five years as you've suggested.

    3. CommentedMichael Holt

      Correction to the correction: the author stated that the undelying assumption is to rollover ten year bonds every year, not to buy and hold a ten year bond for five years as you've suggested.

  7. CommentedSimon van Norden

    Feldstein's claim of a "bubble" in bond prices has some uncomfortable implications that he downplays.

    1) Bubbles in finite-lived assets are not rational in the sense that someone must rationally be expected to lose money buying the asset. He doesn't explain why investors continue to hold large quantities of these bonds despite this.

    2) He tries to blame high bond prices on artificial demand from the Fed's program of bond purchases. That doesn't explain (a) why interest rates didn't rise when such purchases stopped or slowed, (b) why there are similar (or lower) interest rates in countries like Japan or Switzerland or Canada or Germany, which do not have similarly aggressive bond purchases, (c) why a small demand *flow* for bonds is not swamped by wholesale selling of the *stock* of bonds at inflated prices.

    3) A claim of "Bubbles" is effectively the same as claiming "I have no fundamental explanation for current prices." Others (Krugman comes to mind as an example) argue that low bond prices reflect low growth prospects. Feldstein would be more convincing if he rebutted such claims directly.

  8. CommentedProcyon Mukherjee

    The fundamental question is what happens with the sparking of inflation expectations and in absence of it the investor behavior is inclined towards bonds, which when the expectations reverse, that is when people anticipate an increase in inflation—and the corresponding decline in the purchasing power of their money (which in the current liquidity trap is missing)—they are more likely to invest their wealth in real assets, such as land or commodities. But people are currently basking in the glory of inflation-protected-savings, which as Feldstein has shown has its limits.

    Krugman and many others are right that perhaps the salvation lies in raising inflation expectations, together with some 'real' fiscal actions on the ground (not just talk) that raise employment.

  9. CommentedKen Presting

    One expects a Reagan/Bush appointee to stand up for the welfare of the 1%, and Prof. Feldstein certainly delivers. He has nothing to say about the effect of low rates on employment, but he agonizes over any loss of capital gains.

    Unemployed workers are losing productive years now, which they will never get back. Not only lost wages, but also mounting debt, erosion of skills, and family crises. Feldstein can't spare a single mention of their losses.

    Let's not forget how that risky capital can also be invested in new ventures, new plants, and new equipment. Why are companies sitting on cash in the bank, or investors chasing a few basis points by going after T-bonds? Why aren't we seeing productive investment?

    We've all heard the GOP blame over-regulation, but no amount of complexity ever deterred a hedge-fund or derivatives broker. What industry needs is demand, and demand comes from consumers who spend what they earn - assuming they are employed.

    The wisdom of Fed policy now is that they are simultaneously creating good conditions for investment (low rates) while punishing investors who'd rather clip coupons than read through a stack of new business plans. This encourages higher employment, which is the true solution for all classes.

    Feldstein is right that some investors could end up losers. But it's unconscionable to ignore the working class.

    1. CommentedJ. C.

      you affirm: "Unemployed workers are losing productive years now, which they will never get back. Not only lost wages, but also mounting debt, erosion of skills, and family crises. Feldstein can't spare a single mention of their losses." Maybe the right question to ask is: Are the record low rates being effective on fighting unemployment? and will they be in the long term? I guess they won´t if you can´t guarantee that those cheap funds will be invested in high value-added and profitable projects... As long as those funds remain in banks, bonds, primary goods or fly back to real estate, you are not creating the jobs of the future...
      Also, remember bond market losses may not affect poors in a very obvious way, but they certainly do through their pension and retirement plans and other savings... In general, richer, most sofisticated investors have access to other kind of hedges and have better timing than common less sofisticated investors, who will be the ones that bear the costs of losses when rates rise... This "bubbles" are just making the rich richer while giving the poor a placebo...

  10. CommentedCarol Maczinsky

    Low interest rates are good for fiscal consolidation.

    1. CommentedJaroslaw Przybyl

      Perhaps (if we do not take into account possible distortions caused by the very policy) in theory it's good for fiscal consolidation. In practice however the examples of US, Japan and UK don't seem to be a fiscal consolidation success stories. It's rather the other way round: it stimulates deficit policies even further (Germany seems to be the exception in this matter). Instead of tackling their unsustainable growth models they use a palliative that only kick the can down the road.

  11. CommentedCraig Hardt

    Dear Professor Feldstein,

    Could you give a little more evidence to back up your assertion that the current policies of the Fed (presumably its QE policies) are "very likely" to lead to higher inflation than the 2.2 percent projected by the CBO? Thus far, inflation has been at or slightly lower than the 2 percent goal of the Fed and there hasn't been much evidence that that's going to suddenly change. What, in your opinion, makes high inflation a "very likely" outcome of the use of unconventional monetary policy by the Fed?