For those of you who’ve recently returned from a year on a deserted island with no news of what’s been going on I want to let you know that interest rates have fallen precipitously (pretty much everyone else knows this but few know why, which is the reason I’m writing this article).
At the beginning of last year the 10-year Treasury note was trading around 3.0%. Since that time it has slowly but steadily fallen, and as of February 2nd it bottomed out at 1.67% before rebounding to 1.99% as of the writing of this article. It’s all time low rate during the past 50 years was 1.64% occurring on May 1, 2013 so the February 2nd treasury yield was very close to the absolute bottom.
What’s causing the interest rate decline? There are 3½ reasons why yields on U.S. Treasuries have fallen:
1. When there is a financial crisis abroad that threatens the investments of foreign investors their natural response is to take their money out of perceived higher risk or lower quality investments and to invest in lower risk or higher quality investments. This phenomenon is known as “flight to quality.” U.S. Treasury notes are considered by most investors as one of the safest, highest quality investments available. So foreign investors are exchanging their riskier investments for the safe harbor of U.S. Treasuries.
So what crises have we had in the past year that roiled the markets? The big three are: the invasion of Russia into Ukraine, the dramatic decline in oil prices which is causing serious adverse impacts on the Russian, Iranian and Venezuelan economies, and finally but not least, the recent vote by the Greeks to vote into power the Syriza Party who ran on a platform of renegotiating on the Greek government’s debt payments with their European partners. No one can predict how this will all play out but there is a real possibility that this proposed debt restructuring could pave the wave for Greece to leave the European Union. All three crises have led to investors purchasing U.S. Treasuries in droves.
2. In comparison to the yields on 10-year bonds from other countries, U.S. Treasury rates are looking rather bullish as shown below:
1.99% United States
1.48% United Kingdom
If you were a European or Japanese investor looking for a safe place to park your money which country’s 10-year bonds would you purchase? Everything being equal you would choose the country with the highest interest rate and the lowest perceived risk of default. Notice that Italy’s yield on their 10-year bond is fairly close to what the U.S. is offering. Assume they were equal, that the interest rate for both country’s bonds were identical. Which country in the short run has the higher probability of default? The United States or Italy? It’s a no brainer. I won’t even insult you by providing the correct answer.
3. In the past year, the value of the dollar has increased 13% when compared to a mix of foreign currencies. You might be thinking that a strong dollar is great, and in some ways it is. Goods that we import will be relatively cheaper as a result of a stronger dollar. If you want to travel overseas, now’s the time as the cost of travel will be significantly cheaper for U.S. vacationers. Conversely, U.S. exports will be that much more expensive to our trading partners. For example Proctor & Gamble which sells toothpaste, laundry detergent, diapers and other similar consumer products reported 4% lower sales but 31% lower profits from a year ago. Why? Because two-thirds of its revenues are from outside the U.S. A strong dollar is making their products less competitive.
So what does a strong dollar do for foreign investors wanting to park their money in U.S. treasury bonds? Instead of receiving a paltry 2.0% rate of return on their investment, they are actually receiving the yield on the Treasury bond PLUS the increase in the value of their investment due to the increase in the value of the dollar when compared to their country’s currency. So if the U.S. currency has increased 13% annually in relation to their country’s currency then their return on their U.S. treasury investments is not 2% but 15%!!! Who wouldn’t want a 15% rate of return on an almost risk free investment? Is it any wonder why foreign investors are buying U.S. Treasury bonds?
3.5 The final reason why foreign investors are buying U.S. Treasury bonds is the real underlying cause of what’s going on: the world has entered into a new round of currency wars, a policy by which central banks deliberately weaken their own currencies so their country’s goods and services will be more competitive abroad. It started with The Federal Reserve’s policy of quantitative easing. It was followed by Japan’s Abenomics. And now the European Central Bank in recent weeks has vowed to do the very same thing.
Where will this all end? No one, not even the most prescient economists know who will be the winners and the losers of the currency wars. They don’t even know which countries will come out relatively unscathed, let alone which types of investments will weather the coming economic storm the best. It will all just have to play itself out. But I believe that commercial real estate is the best investment to park your money as long as it isn’t over leveraged. Also now is the time to lock in long term low interest rates as they are truly at historic lows. But then what do I know? I’m just a lowly commercial mortgage broker.