Who Benefits From Keeping Interest Rates Low?
Federal Reserve Chairman Ben Bernanke calculates that the benefits of a third round of quantitative easing will outweigh the negatives.
By buying mortgage-related securities, the Fed aims to further drive down house-loan rates to encourage refinancing and induce home buying. Yet mortgage rates have already declined tremendously with no obvious impact on housing activity, and homebuyers certainly didn’t show the enthusiasm for the first two rounds of quantitative easing that equity investors did.
Some observers believe the Fed wants to use inflation and negative real rates to reduce the burden of the Treasury’s huge debt by paying bond holders negative real returns. I am skeptical that the Fed has any sinister motivation. This notion of a policy of “financial repression” belongs in the same category as the mistaken belief that the Fed is hyping its balance sheet and bank reserves to generate serious inflation as a way to reduce the real value of federal debt, also at the expense of government-security owners. Such strategies are the hallmark of the likes of Zimbabwe or banana republics.
Yet the absence of sinister motivations doesn’t mean the Fed’s actions haven’t had distorting effects on the economy. Interest rates close to zero create deviations from the norm and produce a new set of relationships that few forecasters and policy makers fully understand. This low- or no-interest-rate world also has winners and losers.
Let’s look at the beneficiaries. At a zero federal funds rate, the Fed can’t cut any further in reaction to economic weakness. If deflation occurs, the central bank can’t push real rates negative to stimulate borrowing. Furthermore, the lack of response to almost-zero interest rates by lenders and borrowers is what compelled the Fed, and earlier the Bank of Japan, into the new world of quantitative easing. This and other non-interest rate actions taken previously also have pushed the Fed uncomfortably close to fiscal policy and threatened its independence.
While I doubt that the Fed in any way intended to ease the federal debt and deficit, it is important to keep in mind that low interest rates keep the cost of financing the debt low, even as the amount of borrowing leaps. I wouldn’t suggest, of course, that these low financing costs encourage Congress and the administration to delay dealing with the mushrooming federal debt.
Still, after deducting its own operating expenses, the Fed returns the interest it receives on the holding of Treasuries and agency securities to the Treasury, helping to offset the deficit. In a recent speech, Bernanke said that in the past three years the Fed has remitted $200 billion to the Treasury. Central banking is a neat game. The Fed creates money out of thin air, uses it to buy securities and then sends the interest, after expenses, back to the government. How do the rest of us get in on it?
Central-bank rates close to zero also promoted the strange phenomenon of negative returns on short-term government securities. Then there is the recent negative 0.75 percent yield on 10-year Treasury inflation-protected securities, whose returns are adjusted for inflation. If annual consumer-price increases over the next decade turn out to be 2.5 percent, as forecast by the spread between 10-year TIPS and 10-year Treasury notes, the return on the TIPS would be slightly less than 2.5 percent annually.
The federal government, of course, isn’t the only borrower benefiting from low interest costs and negative real rates. Residential mortgagors, if they can qualify for loans, obviously are getting a break with 30-year rates at 3.4 percent.
Investment-grade corporations have been able to issue debt and refinance at low rates, and many are doing so. In July, $75 billion was issued, a record for any July, at 3.2 percent average yields, a record low, and particularly noteworthy compared with an average 7.2 percent yield over the last 30 days. In the third quarter, $257 billion was issued, 64 percent more than a year earlier. To be sure, low corporate-bond yields are partly due to individual investors’ disdain for stocks; and investment-grade corporates also have appeal as havens.
Low interest costs as well as tax deductibility make it attractive to issue bonds instead of equity. Some entities are issuing century bonds. Last year, the Massachusetts Institute of Technology, Norfolk Southern Corp., Berkshire Hathaway Inc., Procter & Gamble Co. and Coca-Cola Co. all locked up borrowing that doesn’t mature for 100 years.
In August 2011, the University of Southern California issued $300 million in century bonds with a 5.25 percent coupon yield, compared with a 3.4 percent yield at the time on 30-year Treasuries. The relatively small premium for an additional 70 years suggests that buyers of that issue don’t see a danger of inflation for many years.
Another winner from low interest rates, and especially QE3, are agency securities. On Sept. 13, when QE3 was announced, Fannie Mae mortgage-backed securities with a 3 percent interest-rate coupon jumped 1-10/32 points, outperforming the 10-year Treasury note by 1-4/36 points. Normally, the performance difference in a trading day is less than 5/32 point. The Fed’s $40 billion-a-month purchase of agency debt via QE3 is the equivalent of a major part of the normal $140 billion monthly issuance.
Dividend-paying stocks have also benefited from low interest rates, despite average yields of only 2.1 percent for Standard & Poor’s 500 Index stocks. Furthermore, the equities collapse in 2008 and the S&P 500’s zero net gain from 1998 through 2011 and no gain in 2011 have steered many institutional and individual investors to bonds and to stocks that pay high, sustainable and increasing dividends. These investors want income here and now as opposed to pie-in-the-sky capital appreciation sometime in the future.
Investors are putting increasing pressure on corporate managements to pay dividends, and in August, S&P 500 companies paid out a record $34 billion. This pressure is also reflected in stock repurchases. Although they aren’t always completed, the timing of actual purchases is uncertain and repurchases sometimes simply offset new issuances to employees, S&P 500 companies have announced $429 billion in equity buybacks for 2012. That’s down, however, from $555 billion last year.
Companies such as Microsoft Corp. and Wal-Mart Stores Inc. that are no longer perceived as growth stocks are under heavy pressure to pay dividends. Wal-Mart’s dividends have risen 5.3 times in the past decade and the dividend yield is now an average 2.1 percent, even as the stock price has risen only about 50 percent in that time.
Interestingly, the total return on dividend-paying stocks beat nonpayers in every year since 2000, except 2003 and 2009. If $10,000 had been invested in nondividend-paying stocks in 1979, it would have been worth $250,000 in 2010, but the same amount invested in dividend-payers would have risen to $413,000. Part of this superior result, of course, is the compounding of reinvested dividends.
Interest rates close to zero have also made highly leveraged speculation in commodities very cheap. Still, commodity prices have been declining on balance since early 2011, suggesting that low-cost financing, droughts and other positive factors have been more than offset by the global recession and hard landing in China.
I have always been agnostic on gold. Its price is influenced by so many forces that it is hard to figure out how they play out on balance, and often they cancel each other out. Think about political risk, economic uncertainty, inflation and deflation, central-bank holdings, Indians who buy gold in good times and trade down to silver in bad, new gold-mining techniques, the gold bugs who hold a gold bar in one hand and an AK-47 and dried food in the other.
In the inflationary 1970s, gold leaped to more than $800 per ounce as it was sought as an inflation hedge. Then its price fell for two decades. The current jump seems to be a haven play and also reflects distrust for paper currencies in general. There has been little inflation lately, and the dollar has been trending up, so those factors aren’t responsible. Gold is also probably being propelled by low interest rates, which reduce its carrying costs, and the uncertain atmosphere that surrounds zero or even negative rates. Still, gold returns nothing, and even at zero interest rates, costs money to keep secure and to store.
Tomorrow, I will describe the negative effects of low interest rates.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the second in a five-part series. Read Part 1.)
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