chester spatt is the Pamela R. and Kenneth B. Dunn Professor of Finance at Carnegie Mellon University’s Tepper School of Business and a senior fellow at the Milken Institute. He dedicates this paper to the memory of his colleague Marvin Goodfriend.
Illustrations by dan page
Published July 30, 2020
What a difference a bit more than a decade can make. In February 2007, the interest rate on 10-year U.S. Treasury obligations (the most liquid and widely traded bond in the world) exceeded 5 percent. In early-June 2020, the rate was hovering around 0.8 percent, and a Treasury security due in two months barely yielded 0.1 percent. The interest rate on 30- year Treasuries was just 1.6 percent, while yields on inflation- indexed Treasuries (aka TIPS) have been negative for many years. What’s more, the Federal Reserve has made it crystal clear that rates will be scraping the floor for the foreseeable future.
It’s no secret why this is happening. Since 2008, the Fed has been doing its part to sustain the long recovery from the Great Recession, and it now is committed to doing what it can to minimize economic disruption during the pandemic. More fundamentally, declines in interest rates in recent years reflect both monetary stimulus and relatively lower demand for funding as a result of more limited investment opportunities and the considerable savings sloshing around financial markets. But the reality that dramatically lower interest rates are here to stay for quite a while also highlights the need to rethink some basics of finance.
The Nexus Between Interest Rates and Stock Prices
Prior to the recent sharp drop in bond yields in the wake of the pandemic, U.S. investors had not focused sufficient attention on the implications of what has amounted to a long slow decline in rates. Once the 2008 financial crisis and subsequent Great Recession were only memories, the Federal Reserve did try to re-normalize (that is, increase) interest rates and pull back from its novel emergency program – dubbed “quantitative easing – to bolster the demand for bonds. But the effort at reversal, initially led by Federal Reserve Chairman Ben Bernanke in 2013, faced a variety of market challenges. What’s more, no time seemed to be the right time to return to monetary policy as usual. At the start of 2019, the Federal Reserve again backed off its plans to boost interest rates and to liquidate its swollen bond portfolio after the stock market began to show signs of weakness.
In any case, inflation has continued to run below the Fed’s long-term target of 2 percent, so the incentive to withdraw monetary stimulus had been very modest. The current shocks and anticipated problems in jumpstarting growth as the pandemic tails off reinforces the conclusion that an about-face by the Fed is highly unlikely. A particularly challenging aspect, as the Covid-19 scenario illustrates, is that the flexibility to engage in conventional monetary policy is limited by the reality that the interest rate baseline already is so low. That helps explain why the Fed once again has rolled out unconventional tools to provide liquidity to the economy.
In light of the recent fall in interest rates, the declines in stock valuation understate the decline in the purchasing power of financial assets.
Lower interest rates imply higher stock prices to the degree they lessen the rate at which expected future profits and/or cash flows are discounted. Indeed, this seems to account for a non-trivial portion of the increase in asset prices over the years since the financial crisis. Plainly, though, there is a limit: the stock price declines as the coronavirus spread across the country in late February and March 2020 occurred despite the all-out effort by the Fed to drive Treasury rates toward zero.
The decline in market capitalization earlier this year reflects the reality that the rate at which future cash flows are discounted isn’t the sole determinant of stock price movements. Presumably, the effects of both expected declines in cash flows and the increased (risk) premium over Treasury rates needed to induce investors to hold stock in risky times dominated.
Consider, too, that the stock market’s reactions to the Fed’s two emergency rate cuts during the Covid-19 crisis response (on March 3 and March 15) were quite negative. This reflected an assessment that the specific actions wouldn’t make much difference to the economy – and that these measures reinforced the conclusion (even by very senior policymakers) that the economy was in deep trouble. In effect, lower interest rates were a symptom of the underlying economic challenges. Importantly, in light of the recent fall in interest rates, the declines in stock valuation earlier this year understate the decline in the purchasing power of financial assets.
Whatever the dynamic, it’s important to note that stock owners wearing their hats as consumers are not better off with higher valuations that are solely caused by lower interest rates.
What matters is what they can buy. And if the anticipated cash flows from stock ownership are not altered, neither is buying power. Analogously, while the cost of funding a pension plan is greater at lower interest rates, retirees’ living standards are not enhanced. In fact, if interest rates fall and the pension plan does not have the resources to cover the resulting higher funding cost, pension benefits are at risk.
Interest Rates and Public Pensions
A simple way to gain insight into the problems faced by state and local government pension plans that promise fixed benefits is to consider what happened to their primary sources of funding. U.S. stocks took a steep dive starting in mid-February 2020 after the Covid-19 threat was internalized by the market. Interest rates fell, too, raising bond prices but also increasing the contributions needed to fund long-term obligations.
Financial economists have long argued that, to the extent that the pension obligations are truly fixed, their liabilities should be discounted at the “riskless” rate – typically identified as the U.S. Treasury rates matched to the date the payment must be made. Consequently, the extent of underfunding of state and local government pension plans increased substantially in the aftermath of the coronavirus shocks, both due to the substantial decline in value of their securities portfolios and the substantial increase in the cost of funding the pension obligations with interest rates near zero.
Additionally, it has been widely noted that the pandemic only dug the pension hole deeper – that underfunding had previously been considerable, even by the plans’ trustees’ own calculations. Worse, the plans were discounting liabilities at exceptionally high discount rates – around 8 percent a decade ago and even recently around 7 percent.
In my view these discount rates reflect a massive flaw in the accounting treatment permitted by the Government Accounting Standards Board for state and local government pension funds. Such discount rates (based upon historical returns on risky investments without adjusting for risk) lead to dramatic understatement of the pension liabilities and are not in accord with economic principles – or for that matter, with the more lenient discount rate that would apply if the discount rates used were the rates available on AA corporate bonds, as suggested by the Financial Accounting Standards Board for corporate pension plans. Of course, this flaw has now been magnified by the prospect of near-zero riskless interest rates extending into the foreseeable future.
Falling interest rates tend to increase the market value of assets held by pension funds, but the cost of funding a particular stream of pension benefits/payments rises substantially with declines in interest rates. The bottom line is that interest rate declines are of little or no net benefit to present and future pensioners. More importantly, to the extent that declining rates reflect worse economic conditions and asset values, the pension underfunding is actually exacerbated by low rates. This arose because of the risky investments by public pension plans that were trying to make up for the historic underfunding.
Insurance, Annuitization and Interest Rates
One of the main characteristics of retirement benefits is the potential for converting all or some of the projected benefit into a fixed annuity. Declining interest rates imply less favorable pricing for the annuity because the seller can’t earn as much on the principal. Similarly, the pricing/premium for many insurance products (long-term disability as well as life insurance) is also partly based on expected returns on reserves as well as direct premium income.
It follows that, as interest income from reserves declines, the insurer needs to raise premiums to generate the same expected return, even with unchanging claims experiences. Not surprisingly, since the onset of the pandemic and the collapse in long-term interest rates, life and disability insurers are setting higher underwriting standards and/or raising premiums on new policies.
One additional point that bears emphasis: the importance of investment income to the insurer varies considerably by product. Some policies depend little on income from invested reserves (e.g., term-life policies where the premium resets annually) and some have considerable underlying accumulation (e.g., whole-life policies that commit the insurer to charging fixed premiums). These days, many life insurance policies are hybrids – term-life insurance policies with contractually set level premiums for extended periods.
The demand for guaranteed products that are not priced to reflect the new reality will increase substantially as interest rates decline and the value of the guarantee increases markedly.
Another important parameter in some annuity and investment products is the protection offered by a “floor” – a guaranteed minimum interest rate. One example is the benefit structure of the giant TIAA (Teachers Insurance and Annuity Association) retirement system in which some investment and annuity products have a contractually guaranteed minimum interest rate of 3 percent. When interest on low-risk bonds is above 3 percent, the floor hardly matters. But in the current low-rate environment, the floor is very important – and very costly for TIAA to guarantee.
This leads to interesting predictions about the extent of usage of products with a guaranteed rate. Clearly, the demand for the guaranteed products that are not priced to reflect the new reality will increase substantially as interest rates decline and the value of the guarantee increases markedly.
Interest rate floors are a broader feature of the economy. For example, many adjustablerate mortgages and loans have a lifetime (or annual) floor on the interest rate. At high interest rates these are often unimportant. But at low interest rates, such as the present, the floor may prove a major factor in the value of the loan product and create huge opportunities for those earning interest and huge costs for those paying interest.
Interest Income, Taxes and Targeted Spending
Changes in interest rates influence the incentive to save through movements in income and wealth on the one hand, and the return on savings on the other. Consider that, as interest rates decline, consumers become less wealthy because they earn less on their wealth. That, in turn, tends to lead to less consumption and more savings as households attempt to even out consumption over time. However, reduced interest will also lead to a “substitution (price) effect,” undermining the attraction of delaying consumption.
Hence, the net impact of the two effects on savings is ambiguous. To the extent that lower interest rates reflect less wealth, the optimal level of current consumption and future consumption would both be lessened, so the targeted future accumulation of funds would also be reduced.
One way in which lower interest rates can serve the interest of investors, though, is with respect to taxation. The U.S. tax system is based upon nominal (pre-inflation) returns. The dramatic decline in interest rates (and interest income) is thus partially cushioned by lower taxes. The dynamic between taxes and interest rates is actually more complicated in part because some investment vehicles, such as IRAs, defer taxes. Tax-deferred investments lose part of their appeal in a low-interest environment because the advantage of postponing taxes on interest income diminishes.
Many retirement advisors now only provide simple rules of thumb rather than advice that reflects the sharp decline in expected returns.
As alluded to above, lower interest rates imply that asset holdings grow more slowly over time. Hence, if the asset holder – whether it be the owner of a retirement account, a family trust or a philanthropic endowment – has the goal of smoothing outlays over time or across beneficiaries, the portion of the portfolio that should be used in each time period would be reduced in the presence of lower anticipated returns.
This is no small matter. Many retirement advisers now only provide simple rules of thumb (as in, “you can safely spend 4 percent of your assets annually”) rather than advice that reflects the sharp decline in expected returns. By the same token, universities have been slow to adapt their target spending from endowments – typically 5 percent annually – to the new realities of lower interest rates and returns since the Great Recession.
Making Sense of Negative Interest Rates
We have had some experience with negative real interest rates, when inflation outpaces nominal interest. But the phenomenon of negative nominal rates is relatively new. Of course, sovereign debt has seen negative market interest rates in a number of leading economies in recent years, and for the first time there is serious discussion about the possibility of negative nominal rates on riskless debt in the United States.
The question arises, however, why anyone would actually pay to store liquid assets if they had the option of completing transactions in currency. But there are many enterprises that have limited choices: General Mills, after all, can’t easily pay grain brokers in $100 bills. And, as the late economist Marvin Goodfriend pointed out, there are mechanisms by which central bankers can relax the zero interest rates bound, just as they previously relaxed the fixed price of gold in the 1930s and fixed exchange rates in the 1970s.
Negative interest rates could lead to fundamental changes in behavior and affect rational consumption and savings decisions. For example, while much of the focus in a positive-rate world is on delaying payments in order to pay later in discounted dollars, negative interest rates would suggest the value (to the payer) of accelerating payments in an array of contexts.
One example: the potential desirability of the early exercise of American-style call options (options to buy stock that can be exercised anytime through their maturity). With negative interest rates, the American call option is more valuable than the corresponding European option (that can only be exercised at maturity).
In contrast, in a positive interest rate environment, the American call option and the corresponding European call option have identical market values, as early exercise is never optimal (as long as the stock does not receive dividends).
On the other hand, in a positive interest rate setting, the American put (option to sell stock that can be exercised anytime through maturity) would be more valuable than the European put (an option to sell stock that could be exercised only at maturity) as early exercise of the option to sell can be optimal.
A second example in which negative interest rates turn conventional thinking on its head concerns when to realize deferred capital gains and incur the associated taxes. With negative interest rates, it may make sense to accelerate realization.
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Stepping back, one can make sense of very low interest rates in macroeconomic terms. For example, rapid income growth in Asia over the past two decades has generated a tsunami of savings that has tended to lower the equilibrium cost of capital. Meanwhile, central banks have used monetary tools to maintain aggregate demand and financial liquidity.
This process could, in theory, be self-limiting in the long run because rapid aging and low birth rates in rich countries, combined with a greater inclination to consume in China, should drive down savings and drive up equilibrium real interest rates. But, at the moment, that particular long run looks dauntingly long.
And there’s little question many economies will have to adapt arrangements to accommodate an environment in which billions (if not trillions) in financial obligations must be renegotiated, retirement must be funded very differently and a host of financial instruments must be rethought.
The global aspects of low and negative interest rates are also striking in the context of international economic competition. At the core of the conflict between the Trump administration and the Federal Reserve has been the administration’s call for lower (and even negative) rates.
The White House believes that higher interest rates have led to exchange rates that place U.S. exporters at a competitive disadvantage. Turning the argument on its head, the relatively higher interest rates in the United States in recent years could be cast as an indicator of the relative strength and performance of the U.S. economy.