How Low Can Interest Rates Go?

U.S. bonds have had a 20-year run. When will interest rates begin to rise thus ending the bull market in bonds?

Predictions, particularly of the future, are tough. (Economists have a nearly unblemished record for predicting the past.) The most famous wrong prediction of an economist is probably Yale Professor Irving Fisher's quote that, "Stocks have reached what looks like a permanently high plateau." Professor Fisher made this sanguine statement in October 1929 just before the stock market collapsed by 90% and the Great Depression began.

Professor Fisher was, by some accounts, the world's most famous economist and he made his remarks at precisely the wrong time. This is amazing, but not too different from the record of many economists.

One of my neighbors is a meteorologist (and don't call her a weather lady) for one of the Boston TV networks. She's a bit of a celebrity in the area. I see her from time to time in our building's elevator, and my running joke with her has two themes (neither of them are at all funny). First, I blame her for bad weather and thank her for the occasional nice day. Second, I tease her for forecasts that often miss the mark. Actually, I used to tease her; once she found out that I am an economist, the teasing had to end.

Although their failures are usually less spectacular than those of Pro­fessor Fisher, many seers in many fields have missed the mark by simi­larly wide amounts. Some decades ago I read an article arguing against immigration into the United States . The article said, look we're all immigrants here in the United States (even Native Americans arrived only 15,000 years ago), but enough is enough. The country is finite and filling up. It's just common sense that the United States can no longer accept huddled masses upon its teeming shore.

The punch line was that this anti-immigration piece had been written hundreds of years ago when the country was empty by modern standards. By reprinting the article the newspaper was arguing in favor of immigration.

There are two ways to be wrong in making predictions. Irving Fisher was wrong to predict no end to the trend that prevailed in the roaring stocks and futures trading market of the 1920s. In my experience, it is even harder to predict turning points in powerful trends. This was the mistake of the original author of the anti-immigration piece who thought America was overpop- ulated hundreds of years ago.

When will the bull market in bonds end? In spite of the hazards of pre­dicting market turns, I have a clear answer: The bull market in bonds will end soon, maybe not today, maybe not tomorrow, but soon and for the rest of your life. Actually that's Humphrey Bogart's line as Rick near the end of Casablanca . While prospects are not quite so bleak for bonds, the bull market has largely run its course.

How low can interest rates go? The historical answer is that interest rates can move substantially lower. In the Great Depression, the interest rate on some U.S. Treasury debt fell to 2 basis points (that's 0.02%!). At this rate, a year's interest on $100 is two cents! At around the same time, the interest rate on 3 to 5 year Treasury notes was under 1%. 7 Similarly, Japan has had interest rates below 1% on some of its government debt in recent years.

Even the current low interest rate on U.S. treasuries isn't the lowest possible. Rates can go significantly lower. They cannot, however, go below zero. That may seem obvious, but the proof is actually a bit subtle. Would you give the U.S. government $100 in order to receive $99 back in a year? The obvious answer is no. A far better alternative would be to put the $100 in a safety deposit box and thus still have $100 in a year.

The cost of storage is the key to understanding the lower bound on interest rates. In our society we can store money safely at very low cost. Thus, we can always get at least $100 back in the future for $100 stored away today.

Consider the very different storage world of a squirrel. Squirrels bury food in good times and hope to retrieve some of it in bad times. On their acorn investments, squirrels always accept negative interest rates. When a squirrel saves 100 acorns by burying them, it always receive fewer than 100 acorns back upon retrieval because some have decayed or been eaten by other animals. If a squirrel buries 100 acorns and later eats only 80, it has just accepted an interest rate of negative 20%. Squirrels must accept negative interest rates because they have no better storage options.

Modern industrial societies have highly secure, low-cost storage options for money. A safety deposit box that is rented for a few dollars a year can hold a lot of cash. Thus, unless one fears a breakdown of civi­lization, interest rates cannot go below zero. No one is going to accept a promise of less than $100 for an investment of $100. The fact that interest rates cannot go below zero means that the majority of the bull market in bonds has already occurred. To be precise, interest rates have gone from above 12% to below 4% in the last 20 years. That means we've already seen at least two-thirds of the entire bull market in bonds.

Buying Bonds at the Wrong Time

The bull market in bonds that began in the early 1980s has largely run its course. The majority of possible profits has already been made. This does not mean that bonds are bad investments now, but it does mean that they cannot be fantastic investments.

It is easy to calculate the maximum returns on bonds. Consider our $1,000 investment in a 10-year Treasury bond at 4% per year. How much can our bond buyer make? If interest rates went to their theoretical minimum of zero, the bond would jump in price from $1,000 to $1,400. So the absolute maximum gain on the 10-year Treasury bond is 40%.

Recall that in the early 1980s, I ignored the advice to buy the Reagan bonds. Other investors apparently shared my view. The data on investments into bond mutual funds reveal that investors really started loving bonds only when the stock market tanked in the last few years. In fact, bond mutual funds took in all-time record amounts in 2002. 8 This appears to be another example of investors being completely out of sync with investment opportunities. Bonds were an amazing opportunity in the early 1980s, but by the time investors got really excited about bonds, the majority of the bull market in bonds was over.

In the mockumentary This Is Spinal Tap Rob Reiner plays Marti DiBergi, a filmmaker touring with the world's loudest band. In perhaps the most famous scene of the movie, Nigel Tufnel (played by Christopher Guest) reveals the band's secret. Spinal Tap is the world's loudest band because their amplifier "goes to eleven" and not just to 10.

DiBergi asks, "Does that mean it's louder? Is it any louder?"

Nigel responds, "Well it's one louder. Isn't it? It's not 10. You see, most blokes are going to be playing at 10. You're on 10, here all the way up, all the way up, all the way up. You're on 10 on your guitar. Where can you go from there? Where? . . . Nowhere. Exactly. What we do, if we need that extra push over the cliff, you know what we do?"

DiBergi offers, "You put it up to 11 ?" to which Nigel responds, "Eleven, exactly, one louder." Puzzled, DiBergi asks, "Why don't you just make 10 louder and make 10 be the top number, and make that a little louder?" After a stunned silence, the scene ends with Nigel saying, "These go to 11."

The new version of the Oxford English Dictionary includes "goes to eleven" to mean to put to the maximum volume. The majority of the bull market in bonds is over because, metaphorically, bonds cannot go to eleven. Where can you go from a 4% interest rate on the 10-year Treasury bond? Nigel Tufnel would respond with "nowhere." So perhaps bonds in this environment are not for wimps, but rather for risk-takers.