Record Low Interest Rates…What’s Really Going On? – Part 1

Learn why we are experiencing record low interest rates.

Jan 19, 2015

BPAS-1-19-15-question

At the beginning of 2014, the yield on 10-year Treasuries was 3.00% and the yield on 30-year Treasuries was 3.92%. The Federal Reserve was supporting the bond market through the purchase of mortgage-backed securities, but had started its “taper” in December 2013 with the scheduled end of all such purchases in October 2014. With this schedule announced and known…and the Fed’s “support” for bond prices to be removed by the end of 2014…there were very few exceptions to the consensus view that interest rates would rise during 2014.

In mid-January 2015, the yield on 10-year Treasuries is 1.76% and the yield on 30-year Treasuries is 2.40%…a dramatic decrease in yields almost no one predicted a year ago.

What is going on here?

Now you’ll hear lots of talk about recession in Europe and Japan. And the glut of oil compared to the demand, reducing the cost of a barrel of crude from around $90 to less than $50 in only two months. And a flight to safety. And that yields on our Treasuries are significantly higher than German and Japanese treasury bonds…so our rates have to close the gap.

But there’s something much bigger going on, and the best way to start is to look at the yield on 30-year Treasury notes over the past 30+ years (note the issuance of 30-year treasuries was discontinued from February 18, 2002 to February 9, 2006):

 BPAS-1-19-15-Graph

In essence, long-interest rates have been stair-stepping down since the end of 1981.

Why is this happening?

Most people are familiar with our National Debt, currently at $18 Trillion.  But the real debt is significantly larger…real debt meaning unfunded promises of Social Security, Medicare, and Federal Pensions. The real, yet relatively undiscussed, value of obligations is closer to $70 Trillion. Read more here.

As pointed out on the referenced webpage, this real debt is about $580,000 per household. In 2013, the average net worth of households was $534,600.

Using these two data points, the entire net wealth of the households in the United States is less than the unfunded promises of Social Security, Medicare, and Federal Pensions.

In other words, we would need every dollar accumulated by households above and beyond their own household debt to cover all the unfunded post-retirement obligations of the Federal government…and then some. This would leave nothing to supplement those government programs (kiss your 401(k) goodbye).

Now very few expect the government to take all the net worth of those who have saved over a lifetime to pay for these government retirement programs…but that is what it would take to save these programs as is.

Simply put…the government retirement programs are unsustainable and will eventually need to be trimmed back (even if accompanied by significant tax increases).

So what does this have to do with interest rates?

Long Treasury bond rates are really an expectation of future inflation plus a reasonable return (maybe 1-3%) above that inflation rate. As each year goes by and the realization that government retirement programs are unsustainable becomes more and more accepted, the subsequent realization is that these programs will need to be cut.  And if the programs are cut, that means less income for retirees, and less amounts that can be paid to hospitals and physicians via Medicare. This eventual lower income to retirees, hospitals (and those they employ) and physicians all adds up to a disinflationary or worse yet deflationary scenario.

And that’s why interest rates have continued to fall for more than 30 years.

How did we get into this mess? And more important (for the readers of the BPAS blog)…..what are the implications to sponsors of retirement plans?

Ready to move onto part 2? Simply click here!