Interesting Interest Rates: The Life Cycle of a Key Financial Metric

If you want to understand the last century of finance, it helps to have a general idea of the trend in interest rates since the 1930s. Not only does this explain the spectacular bull market that began in 1982 and ended when the technology bubble burst in 2000, but it also helps one understand why and how the U.S. economy grew so rapidly during this stretch.

In this episode of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield kick off lifecycle week by discussing how and why interest rates have gone full circle since the Great Depression.

A full transcript follows the video.

This podcast was recorded on May 18, 2016. 

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the financials edition filmed on May 18th, Wednesday, of 2016. This show is going to be aired on May 23rd, which is a Monday of 2016. Join us, as we journey into the mysterious world of the wild interest rate. That was my best David Attenborough impression. I'm so sorry and I'm really glad that my job doesn't depend on that, because it was bad. Anyway, my name is Gaby Lapera joining me on the phone to talk about the lifecycle interest rates financial analyst John Maxfield. Thanks for joining us!

John Maxfield: My pleasure as always, Gaby!

Lapera: To our listeners, just a quick note, if anything important happens between May 18th and May 23rd in the financial world, we are not going to cover it on May 23rd because the show is pre-filmed. I'm going to go camping and I hope I don't die and I'm very, very excited. This week on Industry Focus is lifecycle week. Each show is going to talk about the lifecycle of something important to that sector. For example, I believe healthcare is going to be talking about the lifecycle of a drug. On the financials edition, we are going to be talking about the lifecycle of interest rates, which is something that fascinates both John and I. We're very excited to talk about it... Just a quick reminder that you should not take anything in this episode as gospel truth, as a prediction of the future. We can't know what the Fed is going to do with the interest rate -- no one can know that. If we did, we would make a lot of money. You probably wouldn't never hear us again.

Let me set the scene with a chart from the Federal Reserve. The chart starts back in the 1950s and leads into today to 2016. The chart is a chart of what interest rates look like in the United States, the 10-Year Treasury Constant Maturity Rate. It looks beautiful. It looks like an almost perfect idea of what you think of when you look at a mountain. You have this nice little ascent. It looks fairly steep, especially when you hit the 1970s and it peaks in 1982. Then, you start to have this really sharp decline until you get to today. Back in '82, interest rates spiked around 15-16% and now they're around 0%, which is about where the chart started, a little bit lower. The thing about interest rates, like we said, is that they're a cycle. Where the interest rates are today is very similar to where they were during the Great Depression correct, John?

Maxfield: That's right, that's exactly right. After the Great Depression, they dropped around 0% -- they're around 0% today. They're around the same point. To the point that you're making, Gaby, this is really the macro cycle for the financial sector, [...] above all other macro cycles over the past 100 years.

Lapera: We're going to be talking about this part of the lifecycle in particular. The thing about interest rates, they always do this. Right? They have these troughs and these peaks. Before we had central banking, the troughs and peaks were a lot closer to each other. It always comes full circle and you always end up with what you had before at some point. Maybe it doesn't look exactly the same, but it's basically the same things that are happening.

Maxfield: That's exactly right. You have interest rates, they work cyclically. They're supposed to work counter cyclically to the actual business cycle. As things are doing really well, interest rates are supposed to go up. As things are turning down, interest rates are supposed to go down. Interest rates inherently are cyclical. Now, there are really big cycles in interest rates. The cycle we're talking about now is a really huge cycle. This is the cycle that starts basically in the 1930s and ends today, it goes basically 0% to 0% are the beginning and finishing points. Right in the middle, and to Gaby's point, it almost looks like a perfect peak right in the middle of that. In 1982, interest rates had shot up to near 20%, depending on whether you're looking at short-term interest rates or long-term interest rates. Before then, falling back down over the past 37 years to where they are today.

Lapera: With interest rates, interest rates affect a lot of aspects of the economy. One of the most important things that it does is that it affects whether people are investing in bonds or in stocks. Bonds, they are basically a guaranteed source of income that you can buy from the government, which you can buy from your local government, even from corporations. As long as they're not junk bonds, it's basically a guaranteed flow of income. When interest rates are high, the bond's yield is pegged to the interest rate. When interest rates are high you're going to get a lot of people investing in bonds because the yield on the bonds is so good. When interest rates drop down low, bonds become significantly less attractive because the yields are a lot lower. People migrate over to the stock market, which, while riskier, offers the opportunity for much higher yields on your investment.

Maxfield: Yeah, that's exactly right. There is a direct relationship between interest rates and the yield on bonds. In fact, those are, in many respects, one in the same, particularly when you're talking about government bonds. To back the story up just a little bit, the question is twofold: why did interest rates go from 0% up to like 20%, spike near 20% in 1982 and then why did they then fall back to 0% since? If you look at that initial period, from the 1930s to 1982, what we saw was that the Federal Reserve was still coming into form. We're coming out of World War II, all these different things and we're going into new wars, Korea, Vietnam. That caused the Federal Reserve to spend a lot of money. It's called deficit financing.

Anytime you have deficit financing, that is one of the triggers for inflation. You also had the baby boomer generation. Their parents come back from World War II, they have babies. These babies get extremely rich by the 1980s, they're spending all this money. Consumer expenditures, they also fuel inflation. The other thing that fuels inflation, we've talked about this on the show in the past, there were two oil shocks in the 1970s where oil prices went up... I can't remember what the exact numbers are, but it went from something like $0.10 a gallon to something like $1.80 a gallon. Do not quote me on those statistics. Sharing those to demonstrate the magnitude of the increase.

All those things factored into very high inflation in the late 1970s and early 1980s. The reason that interest rates then increased so much, was that the Federal Reserve came in to stop inflation by increasing interest rates. That is what that steep climb up into 1982 was caused by.

Lapera: Let's take a brief pause and explain to listeners what inflation is and why the federal government would want to halt it in the first place.

Maxfield: That's actually a great question, Gaby. I'm glad you brought that up. Inflation is when the price of goods increases because more people are chasing after the same quantity of goods. Let's say with corn, for example, if the demand for corn goes way up, but the supply stays the same, the price is going to go way up. That's inflation. The reason that demand would go up in this situation is because the federal government is pouring money into the economy as result of a fiscal policy that's based on deficit spending. Also, the Federal Reserve is pouring money into the economy too, as result of loose monetary policy.

Lapera: What this would mean for the individual is, you don't get as much bang for your buck. Maybe your corn cost $1 before, now it costs you $5 to buy corn, just because the dollar isn't as valuable as it once was. That's why it's in the government's best interest to curve inflation. That being said, inflation, a little bit inflation is to be expected and normal. We don't want to kill inflation entirely.

Maxfield: There's absolutely nothing wrong with a little bit of inflation, but there is a problem when you have a lot of inflation. One of the things that it causes, it causes a rapid declines in the value of the dollar. When you are basically the financial center of the world, and you want to attract capital into the United States economy, you want the U.S. dollar to be relatively stable in order to attract those funds in. Very rapid inflation is not a good thing at all, but a little bit of inflation, your 2-3%, which is right around where the Federal Reserve is targeting right now, that is a sign of a healthy economy because it's growing.

Lapera: Right. Between 1971 and 1972, there was a lot of interesting stuff going on with the United States fiscal policy. Do you want to fill us in on that?

Maxfield: This is during the Nixon administration. One of the things that the Federal Reserve did, it was very friendly toward the presidential administration in that opened up the flood gates of money to make the economy look better than it actually was, in order to help Nixon's reelection campaign. This is the story, this is the narrative that is told about the Federal Reserve. It opened up the spigot on money in order to help President Nixon get reelected.

Lapera: What this means for the chart that we're looking at is that it explains why there's this sudden increase on the interest rates as we head into the 70s. The Federal Reserve is trying to help Nixon, we also have these shocks from the oil, and it's slowly bumping up. Even though you see a couple little dips and stuff, it's bumping up, up and up and up, until we get to the 80s. Other stuff is going on. We have deficit spending because of the Korean War and the Vietnam War, I don't know if we mentioned that yet. There is deficit spending going on for the Korean War and Vietnam War. The government's almost always have deficit spending when wars go because that's how you finance war.

Maxfield: Keep in mind that also during the Nixon administration we came off the gold standard. The gold standard, because you're tying your currency to the actual physical amount of gold that you hold, it puts a cap on how much you can increase the money supply. The size of the money supply is directly related to inflation, or it can correlate into inflation. When we came off the gold standard during that time period as well, that also facilitated that rapid inflation.

Lapera: Deficit spending, like we were talking about with the Vietnam and Korean War, do you want to explain why that would help push up the inflation rate, or the interest rate?

Maxfield: You have to filter all this through the law of economics. When the government spends a lot of money, and it's borrowing money in order to do that, it's basically just boosting the size of the economy through debt. If a company were to go out and borrow a bunch of money and then have this insane growth, you would look at it and you'd be like, "Well the reason that they were able to have this insane growth is because they borrowed all this money and invested it." Well that's the exact same thing. When you have rapid growth and demand from additional government spending, they're spending all this money; people have bigger paychecks, more paychecks. If the supply of goods is not able to keep up with the increase in demand, that's when your inflation is going to come about.

Lapera: The other reason why interest rates were starting to spike around the late '70s, early '80s, is because the baby boomer generation was in their 30s and 40s now and they were bringing home big pay checks. This is the biggest generation in America ever, at the time. Their spending a lot more money.

Maxfield: You had literally a perfect storm for inflation between monetary policy, fiscal policy, demographics with the baby boomer generation, and then breaking off the gold standard. That is the reason that inflation went up to like 18% in the late 70s and early 1980s.

Lapera: How does the inflation connect with the interest rates?

Maxfield: Basically what you're asking is, why did interest rates and inflation drop off dramatically after 1982? The reason for that, what the Federal Reserve will do in a situation of when it wants to curve inflation, it will dramatically increase interest rates. If you dramatically increase interest rates, you're going to increase the cost of debt. If you increase the cost of debt, you're going to slow down economic growth, because companies aren't going to be able to afford to go out and borrow as much to grow. Even if they didn't borrow more, the cost to service their debt, their current debt, could potentially go up, particularly if it's not fixed-rate debt. When banks make loans to companies, they often use variable-rate loans. That is really the reason that higher interest rates boosted by the Federal Reserve will slow down inflation.

Lapera: Basically, the Fed was raising interest rates as a check on inflation that was occurring so rapidly in the '70s. That's why it peaks in the '80s. What happens is, when the Fed starts to cut interest rates, a couple things happen. Going back to what I said earlier about the bonds, that's one of the things that happened. That's why you have such a big bull market in the '80s, a phenomenally amazing bull market, because people are dumping their bonds and going into the stock market.

Maxfield: There's a couple different things that go on after 1982. The first is that, to your point, 1982 marked the first year in really an epic bull market in equities in the United States that didn't stop. It was interrupted here and there. In 1987, there was a shock, there was a recession in the early 1990s. That bull market didn't end until the technology bubble burst in 2000. The question is, is there a relationship between the declining interest rate environment and equity prices? I'm sure we'll get to that, and there absolutely is. The other thing that you saw is that the United States economy grew very rapidly through 80s and 90s. That too is directly related to interest rates, the declining interest rate environment.

Lapera: Let's talk about companies and interest rates first. As you mentioned earlier, when interest rates are high, it's more expensive for companies to finance their debt. It's more expensive for consumers to finance their debt. When interest rates drop, companies are excited. They can get loans, they can leverage themselves out much more cheaply in order to expand.

Maxfield: If you're able to expand, if you're able to do that inexpensively because debt doesn't cost very much, then your profits are going to go way up. If you look at the S&P 500, it went from 112 in 1982, all the way up to 1,500 at the end of that cycle in 2000. That was largely because you had people switching out of bonds and into stocks. Also, companies were just making so much more money that the valuation of their shares was going up.

The third thing to keep in mind in terms of the relationship between interest rates and equity prices, is that when institutional investors sit down and figure out the valuation on equity prices, they use these things called discounted free cash flow model. These discounted free cash flow models, basically what they do is they look into the future of a company and say, "How much free cash flow is this company going to make over the next ten years?" Then, they discount that backwards to a present day valuation.

When they're developing that present day valuation and they're discounting it backwards, it's interest rates that they use as the discount rate. It just so happens to work out that higher interest rates will lead to a lower net present valuation, whereas, lower interest rates will have the exact opposite effect. As interest rates are coming down, you're seeing the valuation models and equities, show the present value of equities is going up.

Lapera: Cheap debt is not just for companies. It's also for individual consumers. You'll see if you look at another chart that I also have here in front of me, the average amount of debt relative to disposable income is two times higher than it was in the '80s. That's basically mostly due to the fact that it's so much cheaper to get a loan.

Maxfield: Yes. The reason that consumer debt has increased so much, at least in my opinion, is because debt is cheap. What happened when debt got cheap, is that banks and other type of creditors came up with new products that made it easier for people to borrow. You had all these things that dramatically increased consumer expenditures because interest rates are going down as well.

Lapera: Economies are expanding, consumer debt is expanding. The economy is expanding as well. This is because GDP growth is tied to capital, which you raise via debt.

Maxfield: GDP growth is tied to capital. If you increase capital, another name for capital is debt, you necessarily increase GDP. Another way to think about this is that, if people are going out and getting more and more debt to buy cars and to buy houses and to buy whatever it is, use credit cards. They're going to be spending a lot more money. In the United States economy, 70% of GDP is tied to consumer expenditures. If you're giving consumers more purchasing power by making debt available to them, and not only debt available to them but increasingly cheaper debt over the years available to them, you're going to increase your consumer expenditures. In a country where 70% GDP, like I just said, is consumer expenditures, you're thereby directly going to be increasing the size of your GDP.

Lapera: It's really interesting. A question has just occurred to me which is, if deficit spending increases inflation, which in turn causes the Fed to increase the interest rate, how come the interest rate hasn't risen, despite the fact that we've basically been at war for 20-ish years now, with a few breaks in between?

Maxfield: What is they say? The title of that book was Perpetual War for Perpetual Peace. The thing is that, when you're talking about deficit spending, you're talking about why did deficit spending during the Korean War and the Vietnam play into inflation? Whereas, deficit spending in the Iraq War and the war in Afghanistan, why did those not lead to inflation? The reason is that in that earlier time period, consumers were primed to increase their expenditures. You had the baby boomer generation growing up. You had the ability for people to go out and buy things, their making more money, size of population is larger.

Lapera: Debt is so cheap right now because the interest rates are so low, right?

Maxfield: We're talking about on the way up. On the way back down, today the reason that this deficit spending is not having the impact on inflation that it did back in the 70s, is because aggregate demands, consumer demand, has dropped. The reason consumer demand has dropped is also related to debt. After the financial crisis, people de-leveraged. You had all these people buying houses that they shouldn't be buying, all these people spending money on credit cards that they're probably overextending themselves. Now, they're drawing themselves back in as they de-leverage, as they reduce their debt. They are thereby directly translates into lower consumer purchases. All your deficit spending, your fiscal stimulus right now, the only thing that is doing, is basically offsetting the decline in consumer demand. Whereas before, you had both increase in consumer demand and deficit spending.

Lapera: Interesting. Let's talk about another thing that's directly related to our field, and another thing that we both love which banks. Let's talk about how interest rates affect banks. I think that banks are basically never happy with the interest rate, at least they're never happy for long with the interest rate. As we said, low interest rates means a lot more people are going to the bank asking for money. That means that the volume of business that a bank is doing is a lot higher. If interest rates stay low for a long time, banks aren't going to be happy because they're not going to be making nearly as much money on those loans because interest rates are low. Correct?

Maxfield: That's right. To give you a number to hang your hat on here, if interest rates increased by 100 basis points, which means 1% point, if both short-term interest rates and long-term interest rates increase by 100 basis points, Bank of America (BAC -1.07%) would make $6 billion more a year in interest income.

Lapera: Holy, I can't say that on the air.

Maxfield: That's $1.5 billion more a quarter. If you look at how much Bank of America is making now a quarter, it's making like $2.5 billion, $3 billion, maybe $4 billion. You're talking, if interest rates increased, it's going to make 50% more money.

Lapera: Let's look at the flip side of this equation. Say interest rates are really high, that means banks are making more money on their loans, but a lot fewer people are asking for loans because it's so expensive to get one.

Maxfield: There are a ton of moving pieces when you're talking about banks and interest rates. To your point, we're looking at basically 0% interest rates right now. This is a horrible environment for banks to be in. Banks make money by borrowing really, really cheaply from depositors. Often times, they don't pay any interest rate in the money that they borrow, because that money is in checking accounts. If money is in a checking account, often times it doesn't pay any interest as I'm sure listeners and Gaby and I can both appreciate with our checking accounts right now.

Higher interest rates for their loans that they make, the difference between what they charge out on their loans and what they pay on to borrow is where banks make a lot of money. As interest rates go up, but those demand deposits keep the cost of borrowing basically at zero, that's a very good thing. With interest rates where they are at right now, there's a very small spread between long-term interest rates, which is the basically the rate the banks lend out at and short-term interest rates, which is basically the rate the banks pay at, is compressed at an unprecedented level.

Lapera: Banks are a little bit like Goldilocks -- there is one exact scenario in which they're happy. That scenario is long-term interest rates are high and short-term interest rates are low. This happens when we're on the brink of a recession, basically. The interest rates are still high from the good times before, but the Fed has put interest rates low to cushion the fall that we're about to receive. Banks are happy for about a year and then we're in a recession and people don't want loans anymore.

Maxfield: The other problem is that you have the Federal Reserve come in, drop interest rates. It takes the long-term interest rates a while to catch up and decline at the same rate down to a similar level as short-term interest rates. In that time period, banks have a large spread that allows them to make a lot more money in their loan and securities portfolios. The thing to keep in mind is that, that's very good thing for banks from a profitability perspective.

The problem is that, as you're going into a recession and as the Federal Reserve drops the interest rate down, one of the things that you're going to see at the same time is default rates on loans tick up. Which bank is going to gain, in terms of the interest rate environment, it's going to lose because of loan defaults. To the point that you made at the very beginning, bringing banks into the equation, the fact that they're basically never happy with the interest rates, even when the interest rate is perfect, the interest rate environment is perfect for banks, they still have reason to complain.

Lapera: They're a bunch of whiners, is what they are. Let's go back to the main topic and close our thoughts. Interest rates, they have a very predictable-ish cycle on the macro level. What do you think, are there any investor takeaways from this?

Maxfield: I would say that it's not really predictable. Interest rates are extremely difficult to figure out, what direction they're going to go. Where we're sitting right now, I think it is fair to say that interest rates have only two directions to go, as opposed to generally they have three. Generally, they can go up, down, or sideways. Now, they can't go down. Unless you go in a negative interest rate environment, but even a negative interest rate environment is not going to go down much further from where it is today. You basically made it so interest rates can only go sideways or up.

When you think about what we were talking about at the beginning of this show, about the relationship between equity prices and interest rates, equity prices benefit as interest rates come down. If we're staring at a future where interest rates either stay stable, which seems unlikely but you never know for sure, or more likely that they're going to increase, what does that mean for equity prices?

When I look at it, all my money is in equity so obviously I'm not overly terrified of this. It certainly would lead you to conclude that equity prices may not increase at the same rate over the next few decades as they did between 1982 and 2000. Something can come in, and this is something that Morgan Housel, our beloved Morgan Housel talks about all the time about how difficult it is to predict things. If that is the case, certainly it would make equities less attractive. Although, I would still think they are more attractive than bonds. It's still the game that you want to play. It just may not be as lucrative as it once was.

Lapera: Thank you. This has been really interesting. I feel like I know a lot more about the lifecycle of interest rates on a macro level. I feel like I understand why inflation and interest rates tie together. I definitely understand how banks and interest rates work. I think that's a good summary of everything we've talked about.

Maxfield: I think that covers it.

Lapera: Alright, any last thoughts?

Maxfield: That's it. Gaby, I think you mentioned at the beginning of the show that you're going camping for the first time. Just so the listeners know, not only is Gaby going camping for the first time, she's going camping for a week. She's diving right into it. I hope you have a great time on your vacation.

Lapera: Thank you. Go big or go home is what I don't usually say.

Maxfield: But you will this time.

Lapera: I will this time. In closing, as usual, people on the program may have interest in stocks that they talk about and The Motley Fool may have recommendations for or against, so don't buy yourself stocks based solely on what you hear. Contact us at [email protected] or by tweeting us @MFIndustryFocus. If you want me to send you those charts that we were looking at this week, or if you have any other questions. Thanks for joining us and I hope you have a great week!