Trends in Long-Term Interest Rates

The discussion below comes to us from Editor John Foehl.

The decline in interest rates, which began several decades ago, has started to reverse. For captive insurers, this is a welcome respite, as most have watched the yield on their portfolios sink on a year-over-year basis. While there were signs that rates were headed higher in the fourth quarter of 2018, the 10-year yield has settled below 3 percent again in 2019. As someone who has been a student of the yield curve for my entire career, I thought it might be interesting to peer into the crystal ball and try to divine where long-term interest rates might be headed. 

First, some parameters around this thesis: in defining "long-term," I use this to mean the level of overall interest rates 5–10 years from now. So, this is more like a generative thinking exercise than an actual attempt to pinpoint where rates will be in the future. However, it is instructive concerning how you can use information available today to develop stories about what the future may hold. I have talked about this skill as being a necessary component of any good governance model for captive boards of directors.

Second, I have no real economic or statistical training, so any errors in how I lay out the long-term interest rate scenario below are my own. However, early in my career in finance I served as an asset/liability manager for a mutual savings bank. While there, I convinced the senior management team to begin to develop their own interest rate forecasts. My rationale in doing so was that our own forecasts were no more likely to be right or wrong than all of the economists providing similar prognostications from the Federal Reserve System and major brokerage houses. In setting forth our own outlook, we were vested in how we managed our asset/liability portfolio. I would use a similar argument today for captive insurers looking at potential rates of return on their investment portfolios.

In deciding to write this piece, it was the confluence of two separate news articles that led me down this path. The first, titled "A China Story Far Bigger Than Trade," by Nathaniel Taplin, appeared in the Wall Street Journal on January 5, 2019. The second, titled "Here's to Making 2019 a Year for D.C. to Remember," was a January 3, 2019, editorial piece in my local newspaper, written by Veronique de Rugy, Ph.D., from the Mercatus Center at George Mason University. By combining bits of information from both reports, I created the governance story below on trends in long-term interest rates.

Looking at the China article first, here is the salient section that caught my eye.

Beijing is no longer buying dollars to keep mushrooming trade earnings from pushing up the Yuan, but rather the opposite. Chinese holdings of Treasuries peaked at $1.3 trillion in 2013 and have nosed downward since to $1.1 trillion—a trend that could accelerate in 2019 if new U.S. tariffs further reduce Chinese exports. Less Chinese capital flowing into U.S. government bonds may not seem like a big deal now with yields falling as investors flee wobbly equity markets, but it could weigh on Treasury prices over the long run…. The risk is lower demand for its bonds means the U.S. government has to pay more to borrow. That would drive up rates for businesses and consumers as well.

The article also suggests that China will become a rival to the United States for foreign capital as consumer demand in China grows and savings rates fall.

The editorial written by Dr. de Rugy (Reason.com) is a wish for both sides of Congress to begin to address the issues the country faces, but the finance part of me picked out this one paragraph as being extremely illuminating.

Driven by excessive spending, Uncle Sam has now accumulated nearly $22 trillion in debt. The burden of servicing this debt falls on each and every American. That's roughly $67,000 for each man, woman, and child.

Notice this is only federal debt and does not include any state and municipal debt. Since I live in Connecticut, I chose to aggregate its debt with the federal debt mentioned above.

In 2018, Connecticut had $36.9 billion in bonded debt or $10,310 for every Connecticut resident. So, coupled with federal debt, that means every Connecticut resident owes $77,310. Most people are blissfully unaware of these numbers. In some ways, it's akin to having a credit card bill with a balance due, and you choose to ignore the monthly statements hoping the problem will go away. 

In actuality, however, the problem is really larger than it appears. The debt needs to be paid by taxpayers, not on a per capita basis as it's presented. As reported by Marc E. Fitch, in "Connecticut Taxpayer Burden Increases to $53,400, According to New Report," published October 1, 2018, by the Yankee Institute for Public Policy, using taxpayers as the denominator in the debt load increases the number to $53,400. A similar conversion needs to occur for the federal debt load. Using the "US National Debt" clock at US Debt Clock.org, as of February 4, 2019, that debt load is $179,597. So, as a Connecticut taxpayer, my total state and federal debt load is $232,997. This doesn't include any municipal debt, which is harder to ferret out. Paid as a 30-year mortgage, it would require at today's interest rates a payment of approximately $1,100 per month.

So, in constructing an outlook for the trend in long-term interest rates, just using these two articles you can begin to see key drivers, including the following.

1. China, long a major buyer of US sovereign debt, is starting to pull back based on its own economic trends. In fact, you could assume that China will become a bigger competitor to the United States in seeking to attract foreign capital to service its debt.
2. The US debt load on a per taxpayer basis is significant and is expanding. There continue to be no real discussions at either the federal or state level about starting to rein in spending. In fact, just the opposite is taking place, since neither party has any incentive to tell voters no.

Using history as a guide, eventually the capital markets will begin to impose some discipline by demanding higher interest rates on the debt to compensate for the increased risk of default. How soon this happens to the United States is anyone's guess. For this writer, it's not inconceivable that rates will be higher over the next 5–10 years. For captive insurers doing any sort of long-term strategic planning, this would be a factor I would take into consideration. And, if you don't like my story, feel free to construct one of your own. That's what generative thinking is all about.