Personal Finance: Why do interest rates remain so low?

photo Chris Hopkins

One of the great conundrums of 2014 so far has been the unexpected decline in interest rates. Almost universally, professional forecasters had predicted higher rates this year, now that the Federal Reserve has substantially reduced its aggressive intervention and is on pace to stop buying bonds by October. Instead, just the opposite has occurred, prompting no small amount of head scratching.

By stepping back a few paces and taking in the whole picture, the seemingly confounding behavior of rates looks a bit more rational. It all boils down to a classic case of supply and demand.

A Wall Street Journal survey of 50 market gurus compiled last December produced a consensus forecast for rising interest rates throughout the New Year. In fact, since the end of 2013, the benchmark 10-year U.S. Treasury bond yield has fallen from 3.02 percent to 2.55 percent, a full 15 percent decline and lower than any of the Journal's forecasters predicted. What gives?

First, recognize that the supply of bonds in the marketplace is declining significantly because Uncle Sam is borrowing less. Remember back in 2009, when the budget deficit exceeded $1.4 trillion? Thanks to budget sequestration and improved tax revenues, the deficit is expected to fall below $500 billion in fiscal 2014. That means the Treasury has a lot less need to borrow, and therefore the supply of government bonds is shrinking. Since many institutions and foreign governments need to own U.S. Treasuries, higher bond prices and lower yields have prevailed.

Meanwhile, across the pond, Eurozone economic growth remains lethargic and fears of deflation linger over the continent. The European Central Bank recently cut interest rates in an effort to stimulate growth and weaken the European currency, and yields in many of the Eurozone countries (including Spain and Ireland) are now well below U.S. interest rates. These actions make U.S. dollar-denominated holdings relatively more attractive, causing foreign capital to flow into American bonds and force down yields in this country.

Certainly demographics also play a role. With the aging of the Baby Boom generation, more investors are moving into retirement and taking actions to mitigate risks. That means more bonds in their investment portfolios to serve as an anchor against potential turbulence in the stock market and as a source of income. More demand in the face of dwindling supply.

Finally, an important constituent of interest rates is the expected bite of inflation going forward. No doubt we will someday experience sustained upward pressure on prices during some future period of robust economic growth. But for now, global commodity prices are falling, oil is plentiful, and wages are stagnant. All these factors argue for a quiescent inflationary atmosphere for the medium term. That trend is likely to help limit the upside to interest rates.

It's a killer for savers and retirees looking for income, but it's broadly supportive of the housing market and business expansion in the United States. And don't be surprised if it lasts for a while.

Christopher A. Hopkins, CFA, is a vice president at Barnett & Co. in Chattanooga.

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