As many of you may already know, the interest rate cycle is closely related to the economic or trade cycle, and in fact interest rates are the main mechanism of influencing economic activity.  It is ironic that debt crises are developing everywhere, in spite of the historically low interest rates. European debt and the recent decline in the value of the Euro have made international markets volatile. To temper this volatility, here on our home front The Federal Reserve recently said it would keep interest rates at historic lows for an extended period of time.  Once again The Federal Reserve left the Fed Funds target in a range between 0 and 0.25%, just as everyone expected. The Fed has kept interest rates near zero at every meeting since December 2008. During  its’ two-day meeting in May, the Federal Open Market Committee said that the U.S. economy continues to strengthen, but the slack left over from the recession is still so large that it expects interest rates to stay near zero for an "extended period". Is this normal for US interest rates? Are we entering a time similar to Japan’s interest rates? Has this ever happened before? Is it different this time?

Before we leap into the details behind our bold interest rate prediction, we would like to state that the consensus opinion thus far has been wrong. Every news channel, every newspaper, and every anti-Obama commentary which has claimed that the banking bail out will flood the market with money causing interest rates to spike is incorrect. Furthermore, the theory that there will be a new spark of inflation and a dramatic raise in interest rates is hogwash.  In fact, these theories do not hold water nor can it hold oil. Why? There is too much human psychology in the market and of course, there is supply and demand. The present state of the market has proven this to be true. When investors buy bonds (what fearful investors are buying), interest rates decline and bond prices skyrocket. This is a major contributor to the low interest rate environment. Is this due to the mindset of investors?   

Remember when…
A majority of current investors started their careers in the 1970s. During the 1970s, Americans experienced high inflation, a prime rate above 20%, and unimaginable mortgage rates, which hit 14%. The inflation rate of the 1970s was tracking all time highs. There was a mix of a high demand and a low supply of  jobs, houses, cars, and other tangible products. One reason for this high inflation was because no one wanted to take office as the Federal Reserve chairman. Many under estimated the effects of the inflation problems and no one really had a mandate to stop the inflation either, so prices kept on rising and rising. It wasn’t until Jimmy Carter appointed Paul Volcker Chairman of the Federal Reserve (replacing Arthur Burns) in the summer of 1979 that there was an influential policy maker, who placed a sufficiently high priority on stopping inflation. Another thing that caused inflation was that the investors and creditors had no confidence in the bank system. And of course, we can’t ignore that the 1970s experienced a high level of unemployment. Does this sound familiar to anyone?

Believe it or not…Nine out of ten of my clients within the last year have told me that they fear the inflation of the 1970s will repeat itself. Thus we haven’t seen the bottom yet. I say, “Quit watching Fox News!” We can’t fall much further, so within the next 18 to 30 months interest rates must began their upward cycle. An increase in interest rates will positively benefit the Real Estate market. Sure, interest rates will affect mortgage payments, but people will be afraid of missing out of buying at the low. Remember, fear can drive a market. People will buy. The investment community will witness three forms of sellers: 1.) International investors selling US treasuries, 2.) Hedge Fund and Mutual Fund managers liquidating bond holdings to meet redemptions, and 3.) the Government continuing to issue Treasury Securities to fund our historically large deficits.  This forced redemption will cause a gluttony of bonds on the street. We will experience an oversupply. Thus we will see a reduction in investor demand and a decrease in bond prices will occur between 2012 and 2013. At this point, interest rates will likely start an incline. SURPRISE! Most investors and media sources will disagree with our philosophies, but we are firm believers in this viewpoint. 

...Let’s go back in time…

Investors and advisors need to recognize the importance of examining and analyzing interest rate cycles in order to anticipate future economic and trading cycles. Customarily, interest rates have cyclical long term upward and downward swings. An entire cycle including a down turn and an upward move takes about 60 or so years. The most recent two cycles (1861-1921 and 1952-2013—keep in mind the Great Depression fell in between these 2 major cycles) had a lifespan of roughly 60+ years. We cannot claim that the high point of any interest rate move is exactly 30 years—it is an approximate time frame. In fact the current cycle, which began in 1952, reached its high 28 years later, in 1980. As you can see in the chart below, we are approaching the natural end of a “30 year” period of declining interest rates. In fact, I would predict that we will bottom out in 2012-13. (Although, everyone on CNBC is predicting rates will be rising by the end of the year.)  Historical mapping of interest rate trends shows that they will hit the low in the next couple years and a turning point will inevitably happen. In other words, financial markets will enter into an upward interest rate swing by 2013.  Even the most experienced investors (and advisors alike) will not be able to take advantage of the market experience that they have collected in their lifetime. The knowledge that is needed for the next 30 years would best be based on period between 1948-1980.  (www.Ibbotson.com). Therefore, we will base our forecasts on historic data and economic cycles (and let's not forget investor behavior) from that period in time . Thus advisors must be prepared to revisit historical trends in order to prepare for the future. History is likely to repeat itself; consequently prudent advisors must be aware of what worked and what didn’t work in the past.

…A Little More Research…

The first massive rise in bond yields and interest rates ended in the early 1980s. Since the 1980s, yields and interest rates declined in a secular correction (except for 2 major hiccups) which is currently coming to an end.  Like I said before, I would predict that the cycle will start increasing in 2012-13. After 2013, we will see another increase in interest rates starting the upward swing (the first 30 rungs of the ladder) of the 60 year cycle, which I would suspect would be peaked out in roughly 2042, if historical economic cycles continue.

But why do interest rates drive long-term market cycles? The truth is an investor should not simply ask why, instead investors must ask HOW. Here are just a few examples of how interest rates impact the market: 1.) Higher interest rates make it more expensive to borrow money. If consumers and businesses are not borrowing capital, economic activity (measured by nominal GDP) typically slows. 2.) At high interest rates, investors will rather invest in treasuries or bonds than in the stock market because these investments produce higher interest payments. 3.) However when interest rates are low, generally the contrary is true. In this case, it is so inexpensive to borrow money; it is common to see liquidity and the velocity of money increase. In the past 4 years, this has not been the case because of the uncertainty caused due to the lingering effects from the credit crisis. 4.) In addition to spending trends, the changes of interest rates also affect investors’ core investment behaviors. For example, when interest rates are falling, investors in long-term treasuries or bonds make significant gains. But when interest rates are expected to rise, investors tend to avoid fixed rate instruments.  5.) Businesses which are unable to achieve acceptable rates of return by hoarding cash are driven to invest in projects to increase shareholder values; hence, increasing capital spending due to the low interest rate environment. The bond market is a good indicator of investor and business behavior.

We are not claiming that the bond market itself causes interest rate or market influx. Instead the cause is fiscal policy, expansion and contraction of monetary policy, and economic cycles. The levels of interest rates and the bond market are the effects of these policies.

While we are predicting that interest rates will begin increasing in 2012-13, it is important to note that due to increasing government deficits, a surplus of US Treasuries, fearful investors, and a 30 year bond bull market, we believe the interest rate cycle will also bottom out in the near future---and will continue to stay flat and near record low levels for 18 to 30 months.

With this said, we must expect an upward trend in interest rates and an decrease in bond prices. Furthermore because economic activity is based on human behavior, we also can’t ignore that investment trends are inherently based on life experience.  In other words, a person often limits investment decisions to their individual life experience. Sure parents and grandparents tell their children and grandchild about the inflationary/deflationary events they lived through, but at some point, they are all gone. Once these stories aren’t told anymore, the memories of these economic conditions are too often forgotten.  There becomes no living memory of the previous economic behaviors and so the new generation must learn the lessons again. Like we mentioned before, Baby Boomers remember the tremendous inflation of the 1970s and fear it happening again. But how many investors have any living memory of the Great Depression? It’s very limited—if any. With the fading memory of life before the 1940s, society is far more likely to repeat it. 

History shows that interest rates will certainly bottom out. I would forecast that we only have a few more rungs down the interest rate ladder until 2012-13 and then we need to gear up for the upward 30 year climb.

Sources:
Bloomberg, Bank of America, and www.data360.org
 
Stock Cycles: Why stocks won’t beat money market over the next 20 years, published in 2000. Author Mike Alexander.

The Kondratiev Cycle: A generational interpretation, published in 2002. Author Mike Alexander.