A recent newspaper article stated that interest rates “have nowhere to go but up.”
This means that bonds increasingly are not attractive, which currently is conventional wisdom – as so many agree with that, However, usually nearly unanimous opinions about investments are not rewarding, whereas contrarians quite often benefit tremendously
The major concern now is that when interest rates and inflation begin to rise again, probably very soon, existing bonds will decline in value because new issues will have to pay higher rates.
The only economic factor that correlates almost all the time with long-term interest rates is the core consumer price inflation rate, that is a number that excludes the volatile items of food and energy.
It should be noted that the bond market, more than any other trading medium, is an emotional one. Most in the financial industry shun bonds; commissions on bond transactions are much lower than on equity or commodity trades. Too, bonds traditionally have been favored when people are bearish on the stock market, generally a rare opinion in that sector.
If we look at history, periods of high inflation primarily were associated with war and the increased credit demand that entails, along with more inflation. Usually there followed brief periods of deflation, but soon thereafter stable prices ensued. Hence, inflation, at least core inflation, seems to come in brief bouts.
The Great Depression of the 1930s changed the pattern dramatically. People saved rather than spent, and, of course shunned equity investments. The 1970s had the opposite effect. People no longer believed in “pay as you go,” but began speculating on ever rising prices, and therefore taking on more debt.
Excessive debt was accompanied by an enormous expansion of government spending on “entitlements” and huge budget deficits. Eventually, when people accumulated too much debt the interest payments made those debts unsustainable. Pervasive defaults on mortgages and other debt obligations skyrocketed. Governments also were burdened by their efforts to support the weakening economy; dwindling revenues entailed soaring budget deficits. The entire financial edifice appeared to be coming down. Then, changes in consumer behavior emerged, so governments began to discover that they also had to retrench. That contributed to the economic contraction, with less debt being piled up, and, ultimately, deflation.
If over the next year or so we have moderate deflation with prices falling by 2 per cent a year, the current 3 per cent rate on long-term government bonds means a combined return of 5 per cent. An objective analysis implies then that such very high interest rates surely will decline, not rise as so many now assume.