The supply and demand of money can have powerful consequences. Interest rates seem like a background feature of our lives, but they both reflect and drive major shifts in history... and your wealth.
The "Great Bullion Famine" of the 15th century was one of those turning points...
Europe, in the Middle Ages, was largely on a hard-money standard. Coins made of gold and silver facilitated trade. But as Europe demanded more spices, dyes, and other goods from Egypt, Syria, and Cyprus, these imports grew faster than Europe could mine new silver and gold.
In short, there wasn't any money to trade.
One wealthy man of the time – Jacques Coeur, the French master of the mint – used his immense access to cash to get a monopoly on French trade. Once he had so much of the money in France, he was able to lend it out at high interest rates (until his debtors had him imprisoned).
You might ask why we're looking back to the late medieval period. It's for a particular reason: The Great Bullion Famine caused one of the last major spikes in interest rates... before a long, long decline.
As we'll discuss today, interest rates tend to move in one direction: downward.
But amid that long-term decline, temporary interest-rate spikes can give us an opportunity to collect more income from cash.
We're in one of those times right now...
While interest rates seem like a complex, confusing, and ephemeral feature of the financial world, they represent one simple thing: the price of money.
If you need money to invest in a business or to fund your lifestyle, the price you pay is the interest rate. If you have money and would like to "sell" it to others in the form of a loan, you get paid the interest rate.
And like all prices, the interest rate is set by the supply and demand of money.
When money dries up, the folks who have money can demand a high rate of interest to lend. If you have a business or other enterprise that requires investment, you have to pay dearly for capital.
Today, we have mountains of capital and wealth built up. The Industrial Revolution allowed folks to produce more than they can consume. The folks who manage institutions, sovereign wealth funds, pensions, and more are all searching for productive places to put all this money.
At the same time, we have only so many productive uses of capital. There are only so many factories to be built and businesses to be funded.
Wealth has grown faster than production. That's what's driving interest rates lower... in what the Bank of England calls an 800-year "suprasecular" decline.
That means interest rates don't exhibit the back-and-forth fluctuations of a financial market... Rather, rates head lower and lower over time because of structural changes in the economy.
This data from the Bank of England demonstrates that real rates (meaning rates after inflation) tend to decrease by nearly 2 basis points per year, going back to 1317. Take a look...
The Bullion Famine was an exception – and it represents one of the last periods of sustained higher rates before the decline took hold.
In the modern world, the Federal Reserve and other central banks have the power to create (or destroy) money and alter its supply and demand. Private banks also have the power to create and destroy money through fractional-reserve lending. (Innovations that help lenders spread risk or monitor borrowers have also led to lower rates.)
While many lament central banks' "manipulation" of the market, it's better than being at the mercy of the amount of gold and silver being discovered and mined.
On the other hand, it means modern traders and investors are all trying to divine the short-term direction of interest rates – no easy task.
Recently, the market expected the Fed to undergo a few more rate hikes to bring rates from 4.5% to a peak of 4.75%, then have them fall.
But the economy has remained strong. And the market now thinks the Fed will hike more and go higher to 5.25%.
That shift has hit the prices of both stocks and bonds... driving yields higher.
At the same time, markets place different interest rates on bonds maturing at different times. This is the "yield curve"...
Currently, you can collect roughly 5% on a six-month or one-year bond, but only about 4% (per year) on a two-year bond and just 3.4% (again, per year) on a 10-year bond.
This runs counter to the "normal" scenario, in which locking up money for the short term brings you lower interest rates than it does over the long term.
This situation is called an "inverted" yield curve. It means that the market is concerned about the future and expects lower rates of economic growth down the road – and thus is willing to accept lower interest rates on bonds maturing, say, 10 years out.
If you isolate the difference between the two-year rate and the 10-year rate, you can make a chart showing just how dramatic the inversion is, even compared with the fearful periods of 2008 and the dot-com recession. Rates aren't going to stay this way for long...
Put it all together...
- Over broad history, rates tend to go down.
- Interest rates are close to what will likely be the short-term high.
- You can earn higher rates on short-term bonds than longer-term bonds.
This leads to something important...
Rather than the 0% to 1% you would have earned on bonds a couple years ago, you can get 5% with no risk today.
We're in a unique period of time. The opportunities for income investments are unlike what we've seen in recent years. Make sure you take advantage of them.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
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