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Lack of Interest

August 4, 2012

A Lack of Interest – But No Apathy

How low can they go? Interest rates, that is. In June, the yield on the 10-year US Treasury bond reached a new low of 1.47%, breaking the previous low of 1.48% in 1947. Then on July 16, the yield went even lower, dropping to 1.44% during the day before closing at 1.46%. Seeing these numbers, is easy to see why some financial commentators have called current savings account offerings the “land of no return.” But while the returns from many guaranteed accumulation options are historically small, there are also some advantages for consumers in this low interest rate environment.

How low can they go? Interest rates, that is.

In June, the yield on the 10-year US Treasury bond reached a new low of 1.47%, breaking the previous low of 1.48% in 1947. Then on July 16, the yield went even lower, dropping to 1.44% during the day before closing at 1.46%. And when financial commen-tators speak of record lows for the US economy, the time frame stretches all the way back to 1790, the beginning of the nation! (see chart)

The 10-year US government security yield, which is often cited as a key indicator of the national economy, also reflects the costs for borrowers, and returns for lenders, in a variety of other financial instruments. That same day, mortgage lender Freddie Mac reported the average mortgage rate also hit a record low, at 3.56%. The U.S. Prime Rate, which is the interest rate at which banks lend money to their most creditworthy business customers, stood at 3.25%. The U.S. Prime Rate serves as a benchmark for other interest-based financial instruments, including savings accounts. Here are some annual interest rates for different savings vehicles as of July 16, 2012:

So…this means a 1-year CD of $10,000 will generate $69 in interest. Seeing these numbers, is easy to see why some financial commentators have called current savings account offerings the “land of no return.”

But while the returns from many guaranteed accumulation options are historically small, there are also some advantages for consumers in this low interest rate environment.

The Good and Bad of

Low Interest Rates Low interest rates can be considered a reflection of the relative strength and stability of the American economy. As Marc Gongloff wrote in a May 30, 2012, HuffPost article, “The U.S. and Germany are having an easy time borrowing right now mainly because they are seen as safe havens in a world where every other investment suddenly looks horrible.” Gongloff goes on to mention the financial crises plaguing several European countries, as well as the economic slowdown in China, and concludes that, right now, higher yields and borrowing costs coincide with much higher risk and uncertainty. Even with low yields, global investors prefer American debt because of its perceived safety; in short, the assurance of return of investment here beats the prospects of return on investment almost anywhere else.

A challenge for all prospective borrowers is meeting the tougher lending requirements that have come in the wake of the recent financial crisis. But, if they qualify, today’s lower interest rates have made it possible for many businesses and individuals to reduce the costs of their current obligations. For businesses, lower borrowing costs improve a company’s financial health, and can allow for expansion opportunities. Individuals may find significant savings by refinancing their mortgages, switching credit cards and restructuring other loan arrangements. This combination of tighter lending standards and low rates has helped businesses and households with solid financial footing become even stronger.

Interest rates are driven by two factors: The policy decisions of a government’s central bank (such as the Federal Reserve in the United States), and market conditions. In theory, a decision by a central bank to raise or lower interest rates can be used to “manage” the economy – i.e., to stimulate growth, manage inflation, etc. But market conditions – political events, natural disasters, new technologies, shifts in public opinion – often undo management decisions and render unintended consequences.

In “normal” circumstances, lower borrowing costs could be expected to increase lending; businesses and consumers could use the “easy money” to expand operations, hire more people, buy more stuff. But with the fallout from the recent financial downturn still fresh in their minds, many Americans have been hesitant to take on more debt, even at lower rates. Restructure existing debt, yes – but not borrow more. A January 31, 2012, Wall Street Journal summarized Commerce Department data for 2011: “Consumers are choosing to put more of their income into savings rather than spend it.” A collective change in attitude about debt has blunted the management efforts of government economists.

This save-not-spend behavior reflects the dilemma of one of America’s biggest cohort of savers: retirees. Retirees who rely on their safe, conservative, yield-bearing, financial instruments to provide a secure income stream are severely impacted by low interest rates. Lower rates may mean choosing between living on a reduced income, or dipping into principal to maintain lifestyle. Concerned about running out of money, the prudent decision of many retirees is to reduce spending. The WSJ article found that, adjusted for inflation, personal spending was down in 2011. Again, we see unintended consequences in play: Even though lower rates were intended to stimulate growth, a segment of the population with the greatest amount of cash isn’t spending it.

Will interest rates eventually go up?

The simple answer: They almost have to. When something is at an historic low, the only logical place to go is up. According to data published by fedprimerate.com, the average U.S. Prime Rate since 1947 is 9.842%, and the most frequent Prime Rate value has been 7.5%. Compared to today’s Prime Rate of 3.25%, those numbers may be hard to imagine, for both lenders and borrowers. Then consider that in January 1981, the Prime Rate hit 21.5% – and people were still borrowing! In the past 65 years, interest rates have fluctuated quite a bit. Based on history and the statistical theory of regression to the mean, interest rates should be expected to increase. The next question is: how soon?

That’s hard to say. Remember the unknown impacts of other market conditions. In the 1990s, the financial managers of the Japanese economy lowered interest rates to almost zero following a recession – and rates have remained low for more than a decade and Japan’s economy has stagnated. Then again, some other factor – war, new technology, a change in tax policy – could result in a dramatic change in a very short period of time.

From the perspective of savers, low yields are a definite downer; a change of strategy may be in order. But for borrowers, low interest rates also present some unique opportunities to dramatically improve their financial conditions. In a twist of the phrase, low interest deserves close attention.

One Comment leave one →
  1. Milo Pozzo permalink
    August 15, 2012 7:19 pm

    Hi there! I simply want to give an enormous thumbs up for the nice data you will have right here on this post. I will probably be coming again to your weblog for extra soon.

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