Why do interest rates keep going down, and how low will they go?

by David Gerlitz on July 20, 2012

Interest rates keep dropping to all-time lows, and with them mortgage rates.  The 30 year fixed rate—if you can get it—is reported between 3.5% and 3.625%.  With all the talk of stimulus, tax cuts, and inflation around the corner, rates can’t get much lower, right?

Not so fast.

The story goes that there’s an inverse relationship between interest rates and inflation.  Lower interest rates = additional demand for bank loans, which causes higher inflation.  Conversely, higher interest rates will cut demand for loans and tamp down on inflation.  The reality, however, is just the opposite.  The relationship between interest rates and inflation is much more direct.

To know why, it’s important to understand the causation involved between the Federal Reserve’s actions and the selling of bonds by the Treasury.  Monetary stimulus (lowering interest rates) is aimed at making demand for loans greater, injecting additional dollars into the economy and driving bond yields higher.  Unfortunately, many households are already over-indebted and cannot take on additional debt.  Also, bank lending standards have tightened, to the point where credit is falling, not rising, even with lower interest rates.

Furthermore, long-term rates are really just a series of short-term rates piled on top of each other.  So in lowering the short-term rate to almost zero, the Fed is actually creating a disinflationary policy.

Here is where an often-overlooked transmission mechanism comes in.  The lower interest rates on Treasury bonds go the less interest income the public sector is receiving.  This is a direct fiscal drag which is holding back the recovery, particularly for fixed income investors and retirees who depend upon interest income for their consumption.

If the Fed does continue with it’s methods of “Operation Twist” or “Quantitative Easing”—which is really just terminology for buying Treasury bonds from the private sector—the “additional stimulus” will simply create additional demand for Treasury’s which will continue to drive down yields.  I don’t think we’ll see significant inflation until the Fed reverses course and starts raising rates.

Also important:  the Fed has recently proposed raising capital requirements on banks.  Capital requirements are tricky and a bit amorphous, but essentially they’re the amount of savings a bank keeps on hand in relation to the dollar volume of loans they make.  Treasury bonds are considered Tier 1 capital (like cash), except they pay dividends.  So if the new rules are enacted, the increased capital requirements are also going to increase demand for Treasury’s from commercial banks.  This could be the catalyst for 1% ten year notes.

Finally, with monetary policy stumbling, only additional (fiscal) spending from Congress can inject additional demand into the economy now, and with fiscal conservatives dominating the narrative there, that’s not likely to happen anytime soon, either.

Because of this, I believe the 10 year treasury yield—on which most mortgage products are priced—is going to 1%, and maybe a bit lower before reversing course.  Keep in mind that Japan’s 10 year yield is below 1%, and has been for a long time.  That’s a full half a percentage point lower than rates are now, and point to something close to 3% on a 30 year fixed product.

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