Updated: Jan 10, 2022
By Adam Day, Financial Advisor
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A question we get frequently, as Financial Advisors, is; “Why are rates so low? Long-gone are the days of CDs and savings accounts earning a substantial level of interest. So what factors have contributed to this and why?
Shifting the Overton window.
Instead of looking at current rates as low, we should reframe the proposition as: Current Rates are low, when compared to what?
When we look at a historical chart of the 10- Year Treasury (More to come on this) [Exhibit 1]. We see that the 10-year Treasury in the early 1980’s was around fifteen percent.
Since then, rates have been in a downward trend, to today where the 10-Year Treasury sits between one and two percent. However, context is important, prior to 1980, there was a big climb for the 10-Year Treasury from around four percent, up to that Fifteen Percent [Exhibit 2].
Let us walk through building a profile of the average investor that is trying to retire today. This person is probably in their mid-60s, probably born between 1955-1960. They graduated high school or college and started earning an income somewhere between 1975 and 1985. Which means their beginning in investing in their pension, 401ks, etc. starts around the time of peak interest rates. Bought a home and were offered other savings vehicles during that time. Due to their starting point, this investor doesn’t have the context of what was a ‘normal’ rate ahead of their investing career or maybe the knowledge of the factors that drove rates higher. For example, with restaurants, if a customer has a great experience the first time they go, how likely are they to go back? Typically, very likely. Our Profile investor had nearly the same experience in CDs, money markets, bank accounts, when they started their investing career.
If we expand the window of what interest rates have done historically, we can detach from the point of Peak interest rates where most certainly, today rates look extremely low, when compared. While current rates are indeed still lower than those prior to the peak, the difference is not nearly as drastic as from peak until now.
What is the 10-year Treasury and why is it important?
The 10-year Treasury note is a debt obligation issued and guaranteed by the United States government with a maturity of 10 years upon issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity. The U.S. government partially funds itself by issuing 10-year Treasury notes.
The importance of the 10-year Treasury bond yield goes beyond just understanding the return on investment for the security. The 10-year is used as a guide for many other important financial matters, across the lending spectrum.
This bond also can signal investor confidence. The U.S Treasury sells bonds via auction and yields are set through a bidding process. When confidence is high, prices for the 10-year drop and yields rise. This is because investors feel they can find higher-returning investments elsewhere and do not feel they need to play it safe. When confidence is low, bond prices rise and yields fall, as there is more demand for this safe investment. This confidence factor is also felt outside of the U.S. The geopolitical situations of other countries can affect U.S. government bond prices, as the U.S. is seen as safer haven for capital. This can push up prices of U.S. government bonds as demand increases, thus lowering yields.
The main reason that the 10-year treasury is so important and often used as a benchmark, is due to most companies using this as the ‘Risk-free-rate’ when determining investments to make in Capital Expenditures. Additionally, money managers use this similarly when selecting companies to invest in when determining a minimum expectation for return.
Who sets Interest Rates?
As discussed previously, the 10-year treasury rate is set via a bidding process at auction, via a market system. However, short-term rates are controlled via the Federal Reserve. The Federal Reserve uses the 10-year treasury, as part of their analysis, but their job is to control the Federal Funds Rate. The Federal Funds Rate is the rate, which commercial banks lend their excess cash reserves to each other overnight, sometimes this is also called the overnight rate. This is why the Federal Reserve controls short-term rates, as the shortest-term you can have is overnight. Many factors go into this rate setting such as, unemployment, Gross Domestic Product, Inflation, etc.
Additionally, the Federal Reserve controls the currency supply by adding and or taking out cash from circulation from the economy. We could go down the rabbit hole on the Federal Reserve if we wanted to but it might be better suited as a stand alone topic. Instead, I would recommend that you read about the roots of the US banking system in Ron Chernow’s Biography Alexander Hamilton…. Much more exciting.
In short, current interest rates are generally low due to both the market keeping them low and the Federal Reserve, keeping them low. Much of the current Federal Reserve Policies and Market opinions started back after the 2008 Financial Crisis and continues today in response to the Coronavirus Pandemic.
How do rates effect stocks?
Rates can influence stock prices in a variety of ways. A few of those are:
1. Debt- if a company has variable debt, and rates increase or decrease. Servicing this debt can impact their margins positively or negatively. The same goes for new debt issuance.
2. Capital Expenditures- if investment in expansion must be financed at a higher or lower rate, this might make it easier or harder for a company to take on that venture and expand their cash flows.
3. Market Risk- If the risk-free rate for investors is higher, investors could flee stocks into those risk-free investments for solace.
There are many more factors than the three noted above. When you look at each sector, industry or company, specifically, there is possibly an endless degree of detail on how interest rates changes can influence prices, if you dig deep enough.
Will Rates Go back up?
This is typically the follow-up question to “Why are rates so low?” The short answer is, unfortunately, a nuanced Maybe. There are so many factors and drivers of interest rates, like demographics, GDP, inflation, sentiment, trade policy, the list is virtually endless and comes down to the Fed and Market understanding and weighing the tradeoffs. This makes it so hard to predict and rarely pays off for taking strong bets on either side of the issue. A scenario where we could see rates near the 1980s levels ever again, is probably and unlikely one. However, we have seen some strange things on the other end of the spectrum. For example, Europe having negative rates on their 10-Year treasury equivalents.
What should investors focus on?
Focus on the Long-term. When we invest for a retirement, we are investing for typically +30 years. Additionally, focus on setting a proper asset allocation based on your plan’s goals, timeframe, risk tolerance and liquidity needs. Fixed Income, which is typically the discussion point around interest rate risk, is just one asset class invest in. While interest rate risk is a factor in portfolios, inflation, market risk, investments selection, rebalancing and portfolio review, are all additional factors we should not neglect as investors.
If this topic raises any additional questions, please connect with your financial advisor or bring it up during your next review meeting.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. Past performance is no guarantee of future results.
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