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Say No to Market Timing Bonds: History of Interest Rates

The history of interest rates is fairly interesting, and actually kind of relevant to today as well.  From the worlds of ancient Rome and Greece to today they have played a part in society.

Interest Rates From Outlawed Usury to Pay Day Loans

Let’s rewind 1000s of years.  In the early religious teachings of pretty much every major religion interest rates were condemned.    Basically the feeling was that people could take advantage of others by charging usury, or unethical amounts of interest, to benefit off other’s misery.  Many societies even outlawed the concept of interest rates altogether.   How things have changed. We have swung so far the other direction we now have pay day loans.

The Rise of Lending

Over time society realized the value of interest rates in encouraging loans to others.  Excessive or usury interest rates where still banned, but nominal fees began to be allowed.  Eventually that morphed into what we have today.  Still many states have usury laws, but there is no federal usury law.  This is why pay day loan places are more common in some places than others.

Inflation Versus Interest Rates

But our traipse through history doesn’t end there.  Today many people confuse interest rates with inflation.  Those of you who have read my post on the inflation understand they are related, but not the same thing.   For those who have not read that post, inflation is a measurement of the change in prices of items in the economy.  Interest rates are what you get charged for lending money.  Obviously the price of items today impacts your willingness to lend and to take a loan, but they are not the same thing.  That doesn’t mean one is not used by the government to drive the other.

The Rise of Fiat Currency

Early on in formation of the Americas coins were minted out of precious metals.  Starting with silver and then eventually passing to gold.  The problem was it gave the government limited capability to modify or control the money supply.  After all the more coins were issued the more silver was required.  Discovery of additional sources of these metals didn’t help by reducing the scarcity, and thus value, of the underling metal, outside of the countries control.     

Eventually just to have a fixed payment system the government fixed the conversion rate of money between different forms of currency.  During this time some of the currency was overvalued compared to others.    These issues caused financial instability for the country and difficulty determining correct interest rates.   Add to that the difficulty the government had paying civil war debts and the end of gold and silver as actual currency pushed through during the Civil War.   For these reasons the US transitioned to paper money, known as Fiat money, 

Fiat money was still tied to the value of precious metals at the beginning.  You’ll often hear this period known as the time of the gold standard because the value of Fiat Money was tied to an equivalent amount of gold.  In fact as an individual you could easily exchange your paper money for the equivalent amount of gold without much trouble.

Bretton Woods Agreement

Fast forward to WW1.    Many countries suspended basing the value of their money on the value of gold due to war debts.     Many did return to the gold standards after the war when things stabilized, but the die was cast. The US soldiered on with the gold standard until after the second world war, but suspended the convertibility of fiat currency to gold by the bearer in the 30s.   Countries were still able to convert the US dollar to gold through the 30s.

The Bretton Woods agreement came about 1944 as a way to ensure global trade continued in this portion of transition .  It essentially pegged all currency to the US dollar and the US dollar to a non exchangeable value of gold.  Under this system countries could still convert their currency to gold, but not individuals.  At the very least it stabilized the relationship of money between countries allowing for easier international trade  and international lending.    Banking and interest rates had gone global.

Removal of the Gold Standard, Floating Currencies

Again during the Vietnam war the US government had to spend more than their gold reserves.   Ultimately the government halted the conversion of US dollars by other countries into gold.  In 1976 the government removed the peg to gold completely instead allowing its value to float in relation to other currencies.   This in theory further stabilized inflation rates for the US  by allowing it more control over the value of a dollar.  By stabilizing inflation rates, lenders could more easily define the value of the dollar in the future.  That meant potentially they could set interest rates more accurately encouraging more lending.  Again in theory this resulted in a better usage of lending leverage across the economy for improved production.

Floating Currencies are Still Controversial

A note, the removal of the gold standard is a controversial topic.   Some groups argue the next part I’m about to explain on how the government influences inflation and thus interest rates is too theoretical.  That while interest rates are generally more stable day to day via this floating system, they are too dependent on perception of the country over the long term.  IE if perception were to turn against the government’s ability to pay the value of the dollar would be even more variable than other prior standards tied to a hard unit.  There is credence to this argument as we’ll now explore further.

The Value of a US Dollar Today

What backs the value of the US dollar and most economies today?  Simple, your perception of the faith of the US government to honor the bill’s value.  Yes, there is some aspect of the subdivision of that faith based on how much money has actually been created.  Yes, there is also some aspect that if everyone has more money and the underlying things we buy do not increase then the cost of those things must increase.   

But the tie with the money supply is not 1:1.  Ie. the issues other than changes in perception play at the margins where people don’t have enough to lend or are lending recklessly, not under normal financials.  If the money supply is not causing a credit crunch or reckless lending then essentially any movements in the value of money are due to changes in perception.

How the Government Controls the Money Supply Directly

So the government officially states to control inflation it modifies the money supply.  How does it do this?  Directly the government issues or calls treasury bonds to insert/remove currency from the market.   The government also can adjust tax rates to modify the money supply.

How the Government Controls the Money Supply Indirectly

Indirectly the government acts through the Federal Reserve to control the money supply.  Technically the Federal Reserve or Fed is an independent entity from the government that sets banking rules and lends money to other banks. The Federal reserve sets the amount of currency banks must hold in reserve, called the reserve rate.  A higher rate means a bank must hold more currency to be in compliance, so the money sits in banks instead of consumers or producers.    

The Fed also sets the rates on which it will loan money to other banks overnight, called the interbank lending rate.   The interbank lending rate influences the rate banks will lend to you.  After all loaning to other banks and the Fed is theoretically the most risk free investment a bank can make.  So they wouldn’t lend to anyone else for less.  If high enough coupled with a high reserve rate they may choose to loan more funds to the Federal Reserve and not firms or consumers, thus decreasing the money supply.

How the Government Really Controls the Value of Money

But as you know from earlier in the post, these actions are not really what the government is doing most of the time to control inflation.  The reality is, most of the time the Federal Reserve, and thus the government, is more trying to control your perception of what they are doing to keep inflation stable, rather than actually making changes.  

The statements by the Fed, and the country’s faith in it, are more important than it’s actions.  If everyone were to lose faith in the value of the dollar, the Fed, or the government’s ability to repay debts overnight then the value of the dollar would evaporate.  So I guess what I’m saying is, interest rates are easier to predict in a normal economy under our current system as is inflation.  But a sudden loss in perception of governments full faith to pay back creditors could make our currency and interest rates way less predictable over time.

Modern Day Interest Rates

Which brings us into the modern day.  In 2008 I’m sure anyone not living under a rock remembers we had a credit crisis.  We won’t discuss the causes here or even the viability of the solutions.  Rather I do want to refer to what it means.  During the credit crisis the Fed decided to lower interest rates to encourage lending to consumers and firms. 

Quantitative Easing

The government also chose to buy long term bonds.  This was known as quantitative easing.  Essentially they wanted to inject money into the economy in long duration bonds so people could lend it in the short.   The impact would drive the price of long term debt up, decreasing the interest rate and thus encouraging people to spend.   It was a theoretical, here to unused, way to inject short term credit into a market with a lack of credit.      Did it work?  A very controversial topic for another day perhaps.

Rising Interest Rates

No the reason I bring it up is for what it means now.  Now that the crisis is a distant memory the Fed is unloading these bonds.  They are also raising rates back to normal levels.  In effect a glut of bonds is flooding market with bonds (some of them still long term and some, now years later, of shorter duration).  Higher availability again in theory means lower price.  Lower price means higher yield.    So together in theory interest rates rise for the entire market.  

The Fed’s Actions Now

Today in concert with the repurchase of bonds the Fed is raising Interbank lending rates.  The stated reason being to keep the money supply in check as the economy heats up.  Combined with the sell back of the quantitative easing bonds the government is attempting to reduce the money supply.  It’s also increasing interest rates with both actions.  Since the government sets the lowest level of risk free interest rate in the economy, raising their interbank rate also raises the interest rate on all bonds in the economy.  All basic signs for bonds point to near term increases in yield.

Perception and Now

But… We go back to that pesky perception thing I keep bringing up.  The actual change in Inflation due to money supply changes only helps at the margins, meanwhile perception plays day to day.  The Fed must be perceived to be in control of inflation from day to day to be successful.  Furthermore it must be perceived to be making changes based on the current situation.  Thus in a way they can’t tell you officially what they will do in the future as then they can’t change your perception later.   So when everyone says that the Fed will continue to raise rates, realize that is perception.  It may or may not go down that way.  But in a way, you perceiving that they will continue to do so is the real act of the Fed.   Head spinning yet?

Future Interest Rates are Unknown

So what does it all mean?  The simple reality is just like the stock market the true direction of inflation going forward is unknown.    As a result the future direction of interest rates is also unknown, as the government could change actions at a moments notice in response to perception.  People can blather on all the want about historic interest rate lows, but there is nothing to say a bond can’t have a negative interest rate so that’s hardly true (another post for another day perhaps).    Nor can anyone, and I mean even the people in charge, predict people’s perception over time.  So the reality is no one knows what the future of interest rates will be.  So as an investor in bonds that collect an interest rate, or as a borrower taking a loan what should you do?  

Market Timing Does Not Work for Bonds

The answer is, continue to match your bonds to your liabilities.   With similar terms these 2 can offset many interest changes. Essentially hedge where you can so that up or down interest rates will not harm you too much.    Also continue to invest in areas that do not necessarily move in tandem with inflation like the stock market.    Beyond that, stay the course.    Just like Stocks remember market timing doesn’t work for bonds.

2 Comments

  1. Joe
    Joe September 24, 2018

    I’m getting more conservative as I get older. Now, our bond allocation is 25%. That’s up from 0% in 2008. I think that’s a good move even if the interest keeps going up. The price of bond funds will fall a bit, but we’ll make that up with the interest. The price won’t drop that much anyway. Sticking with an allocation that you’re comfortable with is the key.

    Can you expand on this one – match your bonds to your liabilities? Why liabilities? The only liabilities we have are fix rate mortgages. That wouldn’t change even when interest rate increases.

    • FullTimeFinance
      FullTimeFinance September 24, 2018

      Think of it this way. Who benefits when inflation rises? Those who have fixed debt. The later payments are reduced in real value by the inflation. Those who have fixed return bonds have their payouts decreased in real value. Stated another way those who hold fixed rate bonds are hurt by inflation. Those that hold fixed rate debt are helped by inflation. The opposite also holds true for deflation. So holding both bonds and debt with the same duration hedges any potential move of inflation. Similar things happen with fixed expenses. Now I’m not implying take on more debt but if you have debts duration matching is good practice in an uncertain environment.

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