Interest Rates: Where are They Heading?

There has been much speculation regarding where interest rates are going in the future. Some people think they are going up because of inflationary pressures; others think we are going into a deflationary spiral similar to what Japan has experienced over the last decade and interest rates are going to decrease—even into the negatives; and yet others don't have a clue what's going to happen tomorrow, next week, or a year from now. Understandably, most people are in the latter group. So, let's take a look at all the factors at work and see if we can figure this out. . . .

First, let's take a look at the forces that are at work shaping the U.S. economy and how they are affecting interest rates. It all starts with demographics. The U.S. population is aging and the baby boomers who were born after World War II until the early 1960s have started retiring (in droves). Retired empty nesters are looking to downsize their existing housing situation and move into condos and other smaller, low-maintenance properties that will allow them more time to enjoy life during their later years. Unfortunately, the number of first time home buyers has reduced because there are simply not as many people in the prime home-buying age range of 25 to 49 years of age (as there was in the years after World War II) to purchase their first home. Demand for single-family homes has decreased because there are not as many people in the population available to buy every retiree's home. As demand for a home decreases and supply remains the same, the price of the home will generally decrease. Housing bubbles aside (see Bryan Church's Real Estate Corner No. 1), this is what has been happening to the U.S. single-family housing market.

Secondly, the corporate bond markets have seen many U.S. corporations take advantage of the low interest rates and issue trillions of U.S. dollars in corporate bond debt. If interest rates increase, the value of these bonds will plummet—thus causing companies to lose money and possibly cause another economic recession in the U.S.

At the same time, the Federal Reserve Bank (FED) has been expanding its balance sheet (like drunken' sailors) over the last several years. With so much money going into the U.S. and world economies, it seems as though too much money will end up chasing too few goods and monetary inflation will be the result.

However, this has not been the case so far. The U.S. dollar's position as the world reserve currency and it being used for oil purchases and other trade between countries, has insulated it so far from inflationary pressures. According to history, most fiat currencies that exist without a gold standard are doomed to failure. We can only hope the U.S. dollar will be an exception to the rule.

The FED's Quantitative Easing strategy has masked the true state of the U.S. economy—like a person on steroids who says he feels fine, but in reality is still pretty sick. If the FED stops its Quantitative Easing strategy, it may cause the whole U.S. economy to go into freefall.

Third, the U.S. is now the world's largest energy producer. New fracking techniques have taken previously un-useable shale deposits and turned them into a huge energy source. The U.S. has increased production, along with Saudi Arabia to some extent—although they have vacillated back and forth, to punish Russia for their invasion of the Crimea and their on-going disputes with the Ukraine.

By flooding the natural gas and oil markets, the price per barrel of oil could go as low as $80 per barrel, therefore, causing Russia (a state dependant on gas and oil production for its basic survival) huge economic problems. Their annual budget is based on $100 or more per barrel, and Russia will receive only a percentage of the revenue they planned from their oil and gas output. In fact, Russia may have planned on blackmailing Kiev this winter by reducing their natural gas and oil exports to the Ukraine. This was a planned political ploy to keep Kiev in the Russian sphere of influence and away from the West (European Union). Instead, Putin is in the middle of sorting this out with the West before he loses any more confidence from the Politboro (yes, it's still called that today) and is replaced by someone else. There have been rumors that the Politboro is not happy with Putin's completely missing Kiev's sudden move toward the West--specifically toward the European Union. The Ukraine is an important geopolitical buffer zone for Russia, standing between it and western influences. In fact, the Ukraine has historically been used to slow down and stop invasions from both Napoleon and Hitler.

What does U.S. energy production mean for the U.S. economy? Lower energy costs in the U.S. should cause a reduction in the costs of distribution through the entire supply chain. This in turn should cause a reduction in overall food costs. Food inflation has been an issue over the last few years and a reduction in distribution costs should be passed onto consumers--causing a reduction in food prices.

The 45 million people in the U.S. who are on entitlement programs, especially those on the federal government's Supplemental Nutrition Assistance Program (SNAP) and California Food Assistance Program, receive their food through the use of Electronic Benefit Transfer (EBT) cards and will most likely not be affected by a reduction in food prices. The people who will be affected the most are Americans working part-time jobs and those who earn minimum wage. Their disposable income, used to purchase life's necessities, will enable them to purchase more and better food. It may also leave some discretionary income available to be used for entertainment and other outside activities. I don't think it will be enough income to qualify to purchase a single-family home in the near future, but it will help renters to afford their rent and have a positive effect on the overall U.S. economy.

Some banking VPs in charge of residential lending in the U.S. are looking at 20% down owner-occupied "cookie-cutter" type loans with no private mortgage insurance, solid borrowers, and well-located properties. Even with these conservative loan underwriting guidelines, banks remain concerned that their 80% loan-to-value ratio may not be enough to protect them from a future downward-trending buyers' market where there are few buyers, many sellers, low interest rates, and minimal economic activity.

All in all, it appears that interest rates may stay down for an extended period of time into the future. We could end up with the U.S. dollar devaluing on a world-wide basis, including the possibility of a global reset of over 200 currencies if the International Monetary Fund (IMF) has its way and its drawing rights and market-basket of currencies become the new world reserve currency. The IMF has been buying up gold to use as the basis for this eventuality. China has been buying up gold as well, with the idea that their Yuan or Renminbi will be the next world reserve currency. Unfortunately, they have leveraged their wealth management products so heavily during the last few years that they are starting to unravel and China's growth projections have diminished because of it. With the U.S. throwing huge amounts of oil and natural gas into the international markets, we may still be able to keep the U.S. dollar as the world reserve currency. This is especially true with the U.S. dollar being so strong against other world currencies such as the Canadian dollar, Australian dollar, and Euro.

With all of the above factors taken into account, it appears that inflation may be less of a possibility than it appeared a few short months ago. The four trillion U.S. dollars outstanding (with much of it sitting in reserve in other countries' treasuries—hence the name world reserve currency) will still need to be reeled in by the FED. Inflation has been the traditional way to reel in too many U.S. dollars in circulation, the other way is for a significant stock market adjustment to erase much of the "phantom equity" caused by the FED's QE programs. Many investors believe this is likely and have moved much of the their wealth into tangible assets such as real estate, precious metals, and gems. So, it appears that interest rates may stay down for an extended period of time.

Our next article will be on real estate, precious metals such as gold and silver, and gems. Will tangible assets maintain wealth over the long-term and what are ways to protect yourself from the "over-financialized" stock markets in the U.S. and around the globe.