After much public jawboning, the Federal Reserve lowered the Fed Funds rate by ¼ of a percentage point. It was the first rate cut since 2008 and it surprised no one.
More interesting were recent comments from a strategist at a large money center bank. The strategist opined that over the next few years the 10 Year US Treasury would decline in yield from 2% today to zero.
Let that sink in. You give money to the U.S. Treasury for ten years and they pay you no interest. Although that is virtually inconceivable for any investor who lived through the high inflation Carter years, it is not that far-fetched.
Currently, the U.S. has the strongest economy, despite slowing growth. Unemployment and inflation are quite low. And yet, the U.S. has the strongest currency and pays the highest interest of any developed nation in the world.
That is a bit unusual. Normally, lower credit quality countries would pay higher interest to entice people to buy their debt.
However, other central banks have taken extreme measures to stimulate their economies. Since June of 2014 the European Central Bank has had negative interest rates. Japan, Switzerland, Sweden and Denmark have followed the ECB’s lead with negative rates. That means if you want to put your money in the bank, you will get back less than you deposited!
This poses an interesting question: Why should the U.S. pay the highest interest to borrow if it does not have to? This is especially true given that in 2019 the U.S. government will borrow more than $1 trillion.
There are many arguments as to why interest rates should be higher or lower.
Some argue the economy is slowing and a recession might be on the way. To stimulate the economy, rates need to be lowered.
With other nations paying negative interest, the US has quite a bit of latitude to lower rates. Furthermore, higher interest rates create a strong currency. A strong currency makes it more difficult to export goods and services around the world. Lower rates stimulates exports on a relative basis.
Others think lowering rates is nothing but a ploy to boost the economy running up to the presidential election.
There is also the impact to traditional savers and fixed income investors. Lower interest rates deliver slim returns to traditional savers in money market or a CD. It also restricts cash flows and returns that can be derived from investing in longer-term fixed income assets like a corporate bond.
After factoring in taxes and inflation, savers and fixed income investors will have an extremely hard time maintaining their purchasing power.
This encourages money out of interest-bearing assets into more volatile assets like the stock market. Although this may boost the stock market, it does not make it any less volatile. As such, a long timeframe will significantly help produce the returns most are looking for.
Just a few years ago, the Federal Reserve and Treasury Secretary were worried about U.S. rates going too high. It is easy enough to do the math and estimate that our national debt becomes unsustainable if a US Treasury hits about 6% interest. As such, one could argue that the Fed and Treasury are obligated to lower rates.
These are not easy decisions and predicting the outcome is well beyond our pay grade.
However, if rates decline towards zero all other investors will be forced to move funds into more volatile assets to maintain their purchasing power. Some will have the appropriate time frame and stomach to handle the associated volatility. Others, will not.
Additionally, if your goals are short-term, it will still make sense to emphasize liquidity and return of principal over maximizing rate of return. As such, you may have to hold your nose and accept negative returns on short-term money.
Given this, the best thing you can do is have a well-developed plan ahead of time. This will increase your odds of success by following logic and discipline, as opposed to emotion and hype.