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Balancing Interest Rate Goals

With the Presidential election around the corner, there is a non-stop droning of hollow promises. One promise from both candidates declares that interest rates will go back up as if it is simply a dial you crank a few notches. Although this would be welcome news to traditional savers and conservative investors, not everyone would be as happy. Furthermore, this promise is well beyond the control of any politician.

Low rates punish savers. However, they allow highly-leveraged, junkier companies to stay alive longer than they should under “normal” conditions. Consider companies competing in energy, steel, airlines, autos or a variety of commodity driven industries. These are tough businesses to begin with, typically requiring large debt loads. If rates remain low, it reduces bankruptcies and keeps people employed longer. Higher employment helps to pay bills and circulate dollars throughout a sluggish economy.

Ironically, keeping lower credit quality company’s alive penalizes more conservatively run firms as it increases competition.

Individual savers look to CD’s, fixed income and money market to produce interest income. Twenty years ago it was common for financial planning software to project that retirees would earn 6% from high quality fixed income assets. Today, they’re lucky to earn 2%. This has encouraged the average saver to increasingly wade into more volatile assets.

Sometimes this entails the stock market while other times people dangerously reach for yield in emerging markets, junk debt, real estate or master limited partnerships. Just remember, if the 10-Year US Treasury is plodding along at 1.8% and someone offers an investment with a 7% “interest” rate…remain cautious and ask lots of questions. If it sounds too good to be true, it usually is.

Gross Domestic Product, the total of all goods and services sold in our nation, has struggled at slightly above 2%. Economic growth is the slowest we’ve experienced over a 10-year cycle since the end of World War II. In a market like this, low rates will be used as a stimulus for growth.

The official "unemployment" rate is less than 5%. However, that figure excludes many Americans. Once the numerous categories of “excluded” people are added back, a more accurate unemployment figure is about 10%. If unemployment is that high the government will try to foster growth and, in the process, hopefully encourage hiring and employment.  

One-third of world government debt has a negative interest rate. Let that sink in for a second. You lend money to a government and not only don’t you get any interest, you don’t even get your full investment back. It is a guaranteed loser. In comparison, the 10-Year US Treasury at 1.8% interest is a bargain.

Recognizing this, neither the Federal Reserve or the Secretary of Treasury feel any pressure to raise rates to be competitive with other governments. The U.S. not only has the highest credit quality debt in the developed world, but our rates are higher too.

Additionally, there is much confusion over what the Fed is actually capable of doing. The Fed sets short term rates, while the financial markets set rates on long-term fixed income assets. As such, regardless of what the Fed desires, it may be well beyond their control.

The Federal Reserve Chairman and Secretary of the Treasury both know our nations funded and unfunded debt obligations are increasingly difficult to manage if interest rates increase much.

Currently, the federal debt outstanding is about $20 Trillion. That does not include state, local or agency debt. The interest component is about $250 billion per year with an average rate around 1.25%.

If rates revert back to the “good old days” of 6% the interest alone on the national debt would increase nearly 500% to $1.2 trillion per year!

Given that US Federal Tax Revenues are currently about $3.3 Trillion, interest eats up about 7.5%. If rates rise to 6% the interest just on the federal debt would gobble up 36% of annual revenues.

Obviously, the interest rate discussion is not simple nor one-sided. From where we sit neither presidential candidate has the ability to follow through on increasing rates in a material manner—and we’re not sure they should either.

Dave Sather is a Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.