Interest Rates are Forecast to Go Much Higher – That Puts Us in a Box

Eyes are anxiously turned to the future of interest rates. For years now, pensions and retired investors have suffered under the head wind of very low interest returns that were less than the rate of inflation. On the other hand, super low mortgage rates have supported rebounds in the value of real estate and, most prominently, the stock market. Super low interest rates have also enabled governments to run up huge debts without the public caring. But after 36 years of falling rates, the winners and the losers of suppressed interest rates are watching what happens next.

Thirty-six years of generally falling interest rates may be reversing and some very accomplished people say they are set to rise. Accomplished bond managers Jeffrey Gundlach, Bill Gross and Scott Minerd are predicting, or see scenarios, where rates work higher, even doubling, over the next four years…. and that would mean a new trend has come into place, a trend of rising rates. Sea changes like that matter a great deal.

Breaking a 36-year trend of falling rates will constitute a new economic era with new winners and losers, opportunities and problems. It would be big news. In 1981, interest rates were in the high teens. Imagine that? Falling interest rates meant borrowing to consume. Borrowing to build homes for investment became easier and easier, cheaper and cheaper. Imagine how that would change things if interest rates went the other direction?

Take, for example, the US debt. The cost of servicing the debt would rise in round numbers by $200 billion/year for every 1% increase in long-term interest rates. Add that to the budget deficit.

Take, for example, the stock market. Bonds aren’t much competition when the dividend yield on blue chips is the same as bonds. What if bonds yielded much more? Would money shift away from stocks?

What about property values? What do you think would happen if the monthly cost of the average new mortgage (which is about $300,000) were to increase by $600/month? Rising rates really could put us at that level in a year or two.

There may be winners. Higher interest rates would help pensions and retirees. Public pensions need to earn 6-7% a year. Rising rates would really help them. Public Pensions are only earning about 2.5% on their bonds currently. And that could double, or more.

It is interesting to consider that some very smart people are seeing an historic change coming in interest rates. It is one that affects us all.

There is another interesting aspect of this possible scenario. A better economy force rates higher which in turn triggers some very bad effects on the economy that may reverse the whole process or prevent the increase from happening at all.

The problem is, we are in a box. How does the economy deal with higher interest costs on the $145 trillion dollars of outstanding debt in the US economy? Rates just 2% higher would be adding close to $3 trillion in interest costs. The problem is for some borrowers, there is too much debt for their available revenue. The Federal government, for instance, has $20 trillion in debt. Where does it find the tax revenue to service a 2% increase, or $400 billion in interest costs? The answer is, they do what they do now i.e. borrow to pay interest until they can’t anymore.

When normalized economic growth moves us towards normalized interest rates, we find that our huge debts have put us in a box. It comes down to this. The size of the debt relative to the economy has never been so large, ever. So, when interest costs rise, the cost of servicing debt rises faster than many entities can handle. It is a debt trap, or box.

Our very large outstanding debts create an apparent dead end. The economy’s return to a normalized growth will bring higher interest rates, and higher rates combined with record debt levels will, in turn, be a restraint on the economy. The future seems hampered by the amount of debt we took on since 2008, and before that 2001. Pensions and retirees may be winners, but debtors like governments and overly indebted households and businesses will have trouble paying future interest costs.