Wednesday, October 22, 2008

How Low Will Interest Rates Go?

During the real estate recession of 1990, the 30-year treasury bond traded at 9% in mid 1990 and at 5% in late 1993, a decline of 44%! Will housing construction snap back faster this time than last? There are too many houses in countries from Iceland to Bulgaria. If the thirty year rate were to follow the prior pattern, it would be down to 3.4% in a couple of years and banks would be making huge profits.

There is demand for long term construction money, for nuclear power plants, around the world. For example, Italy has decided to build 8-10 nuclear power plants, having declared the closing down of nuclear plants a 50 Billion Euro mistake. Should a new US congress decide to rebuild bridges across the USA, the demands for long term funding would be significant.

However, for the past several years, China has built interstate highways on a scale never seen before. The point is that demand for long term financing is not the key to interest rates. There are three factors that have been keeping the lid on interest rates; they all have to do with keeping inflation low. 1) In our new global economy, there are ample supplies of labor. 2) There is better understanding and use of fiscal and monetary policies. 3) Innovations continue to boost productivity.

In our global economy, supplies do not get wasted by inefficient users, nearly as much. The age of chopping down trees to burn in out door fire pits is largely over. While it is true that Americans and others drive extra large and wasteful cars, businesses do a good job of finding the low cost producer. Furthermore, the run up in commodity prices has made the citizens of the world aware of the tremendous waste committed. For the next many years, consumers will look for ways to conserve.

We all know that Greenspan let interest rates stay too low for too long during the real estate bubble, but even the current down turn is mild compared to those of the past. Thousands of savings and loans and banks went busted during the last real estate recession. The many countries that built up sovereign funds during the boom times are cushioning the down turn. Petro dollars are being recycled. Substitutions, that result in lower consumption of resources, are being made by the second.

Innovations are spewing out of laboratories across the country and around the world. The most exciting innovations are nano sized. Last week, a fellow at NC State announced a way to "weave" nano super strong fabrics at about 10,000 times the normal rate. Before long, we will need very few people working in manufacturing plants. We can all spend our time inventing something neat or at least offering some service or another to our fellow citizens.

Productivity is better than found money. For one to find a wad of money, someone else must have lost a wad of money. Productivity produces new money out of thin air. At first, the bulk of this money goes to the people who use the new idea to lower cost and increase profits. Before long, productivity shows up in lower prices. Lower prices show up in lower interest rates.

I don't know where interest rates are headed, but I know that interest rates and commodity rates trade together. I also know that, for the first time in many years, China's steel mills are not running flat out. The world wide demand for highly elastic goods has fallen. The price declines are as large as those seen at the end of the inflationary 70's; back when treasury bonds offered 14% returns. Long term treasury bonds paid 2.5% during the 1940's. Stranger things have happened!