In this article, we will walk you through a logical process, using charts, to explain what drives the long rate and why it is likely to remain low for an extended number of years. Our key perspectives will be highlighted.
Big picture background; the long term debt cycle
Ray Dalio of Bridgewater Associates explains the long term debt cycle in a paper he wrote called "How the Economic Machine Works". In a nutshell, debt creation enables more debt creation until debt levels become too large relative to incomes - then either debt needs to come down, or incomes need to rise, before it can resume.
Dalio explains that upswings in the debt creation cycle occur and are self-reinforcing because debt growth finances additional spending growth and asset purchases - leading to rising incomes and higher asset prices. Rising incomes and higher asset prices enable lenders to lend more, and the process repeats, until debt burdens become too high relative to incomes. At this point, central banks step in to assist by lowering rates to ease debt service costs and stimulate further credit growth. But when rates get down to 0%, then central banks lose this ability to stimulate credit growth any further.
This last sentence describes our current predicament and lack of credit growth since 2009, and is the reason the Fed chose to implement a series of quantitative easing rounds to try and pump money into the economy. The chart below shows the Federal Funds rate and Total Debt/GDP. Notice how Total Debt/GDP peaked in 2008 along with a concurrent 0% Federal Funds rate. We are now in a slow deleveraging, whereby incomes need to rise relative to debt levels in order to allow credit creation to resume meaningfully.
Perspective #1: When rates were last at 0% in 1950, Debt/GDP ratio was 125% and real GDP subsequently went on grow at 4% compound per year, for 30 years. Rates are now back to 1950 levels, but our Debt/GDP ratio is almost three times higher today at 325%; so the ability to grow credit is much more restrained than it was in 1950.
Rising versus declining interest rate environment
We are currently in the bottoming stage of a declining interest rate environment. Unless rates drop below 0%, the next phase of the cycle will be the start of a rising interest rate environment, even though it may take a while to begin ascending.
Perspective #2: The driver of long term rates in a rising interest rate environment is via demand for capital for new fixed investment/capital formation - inflation can also drive rates, and we will address it separately further down. The next two charts show the correlation between new investment, shown as the percentage change in the capital stock, and the 10 year interest rate, during a rising and a declining interest rate environment.
In a rising interest rate environment, interest rates respond to changes in new investment; the correlation is good.
In a declining interest rate environment, there is no similar correlation.
Given that new capital formation (new investment) is the primary driver of long term rates, we should understand what is happening to it. The following three charts all paint the same picture; any way you slice and dice it (as a percent of GDP, as a percent of the asset base, or total investment including depreciation replacement as a percent of the asset base) investment spending is increasing at a declining rate.
We are adding to the asset base at a smaller rate every year (from 12% in 1950 to 4% today).
Perspective #3: The primary driver of rates at this stage of the interest rate environment, new investment, is trending down, and therefore there is no upward pressure on interest rates.
Investment spending is a function of growth, and boosted further, if there are capacity constraints. Growth without capacity constraints, does not necessarily lead to new investment if there is a lot of slack in the system, but generally new investment does track with capacity utilization.
The next chart shows the year over year percent change in Real GDP growth since 1950. Since 1990, growth is generally slower than it used to be.
The Congressional Budget Office projects real GDP will grow by about 3 percent in 2015 and 2016 and by 2½ percent in 2017. For 2020 through 2025, CBO projects that real GDP will grow by an average of 2.2 percent per year. The CBO acknowledges that economic growth will diminish relative to the average seen over the past several decades - citing an aging population as a key factor.
In a speech by Ben Bernanke in March 2013, regarding long term rates, he describes the three components of long rates; the short rate + the term premium + inflation. The term premium represents investor's expectations for future growth; if rates are expected to be higher in the future, due to higher growth, then investors will demand a higher term premium today. If growth is expected to be slow, then the opposite is true. Here is the chart of the term premium since 2004, with the current term premium at 0.15%.
In addition to demographics, the debt/GDP overhang will take time to clear, and the Fed is limited in its ability to stimulate credit, so the lower growth estimates seem reasonable at this point.
Perspective #4: With lower growth rates going forward, we expect the downward trend in new investment to persist (further dampened by capacity and technology as explained below) and consequently less upward pressure on rates.
Capacity utilization peaks and troughs have been making lower lows for the last 40 years and are in a downward channel. New investment tracks capacity utilization fairly well; as capacity gets tighter we see higher levels of new investment. But new investment as shown is growing at a declining rate.
Perspective #5: Why is this declining growth rate of new investment and capacity utilization happening? Our answer is that we already have too much stuff, and technology is helping us use what we have more efficiently. The next chart shows the asset turnover ratio (sales/assets) for the economy, shown as GDP/total assets.
The ratio declined for 50 years until 2000, and has been flat for the last 15 years since 2000. It means GDP is not keeping up with new investment, or alternatively, new investments are becoming less and less productive. Even though we have been adding a smaller amount to the asset base every year since 1980, GDP growth has not been able to turn the curve upward.
If this were happening to your business, you would be saying, "let's get some more sales before we build another thing." If we stop adding to the asset base for a while, and GDP/assets started to tick up, this would take up the excess capacity, which would then justify new investment, and subsequent rate increases. Right now we are just treading water, as we have been for the past 15 years.
A note on Profit Margin impact. Asset turnover impacts profit margins, which are currently at record highs. Most of this is a result of a declining labor expense and lower interest rates. You might argue that record profit margins would stimulate new investment, and granted, it has increased since 2009, but companies are hoarding record amounts of cash, or using it for share buybacks instead of for new investment, which tacitly confirms their growth expectations. Lastly, if new investment is financed using these cash hoards instead of debt, it may not affect interest rates much. Now that the labor market is tightening, and if we start to see wage growth, which has not happened yet, this may start to compress profit margins, which I'm guessing will lead to reduced new investment.
Technology is making existing capacity more productive
No charts here, but two examples will suffice.
The first example is AirBnb, which has a valuation rumored larger than Hyatt Hotels, and reportedly sold 37 million room nights in 2014, without building a single room!!. Had AirBnb not been created, it might have led to more physical hotels being built, generating demand for new capital and pushing rates higher.
Or how about Uber predicting their new carpooling service could take 1 million cars off of the road? That's a permanent reduction of about 5% of all the cars sold every year in the US. This would mean fewer auto factories needed, and of course less demand for new capital.
The investment required to build these new technology applications is much lower than building the physical plants.
The trend for inflation is downward.
Inflation does seem to track capacity in a rising interest rate environment, but since 1980 the relationship is weak. The long term trend is still declining. In a more connected global economy, it is more relevant to look at global capacity utilization, since it is now easy to substitute production for many goods and services in another country. Dan Alpert, in his book "The Age of Oversupply" does an excellent job of explaining both the history behind, and the reasons why the global oversupply of capital, labor and productive capacity will keep inflation low.
Currently, 10 year inflation expectations are putting no upward pressure on rates. The TIPS spread is currently at 1.6% - see next chart. The Cleveland Fed ten year expected inflation estimate, which is supposedly more accurate, is 1.53%. This could always change with something like an oil shock but at the moment it looks muted, not to mention that oil has dropped about 50% in just the last six months!
The impact of the Fed
Perspective #6: The Fed does not control the long rate, if short term rates are at 0%. When short term rates are higher, the Fed can influence the long rate, through changes in the short rate, but this capacity is lost when short rates are at 0%. Thus they tried QE. When the Fed ended QE, everyone expected rates to go up; instead they went down.
The asset purchases from QE have mostly transferred assets from the Fed to bank excess reserves. This money has not made its way into the economy, and as Gene Fama pointed out, since 2008, given that the Fed started paying interest on excess reserves, QE is in essence the issuance of short term debt to purchase long term debt - a market neutral event.
In Chairman Bernanke's speech he confirms the driver of rates saying, "In the longer term, real interest rates are determined primarily by nonmonetary factors, such as the expected return to capital investments, which in turn is closely related to the underlying strength of the economy."
Conclusion. Welcome to Japan!
All the evidence presented above makes it clearer why rates have not increased to date, and implies low rates for a while going forward. The combination of debt overhang and the Fed's inability to stimulate credit will temper growth; low inflation, and reduced new investment caused by lower growth, excess capacity and new technologies, will keep rates low.
We may be where Japan was 15 years ago. Here's Japan in 3 graphs; low growth, low interest rates and low inflation.
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