If We’re in a Rerun of ‘30s, Watch Yields Sink
Wall Street’s gloomiest bears now spend a lot of time drawing parallels between the 1990s and the 1930s. The inference is of a collapsing economy and obliterated financial markets.
The problem with those comparisons is that they paint the ‘30s in a monotone--as if every investment either lost value nonstop or stayed static between 1929 and 1940.
In fact, there were many phases to the Depression, and likewise many phases for stock and bond markets in that period. Smart people did make money, despite the somber backdrop.
So even if you buy the ‘90s-are-the-’30s scenario of a slow and difficult economy ahead, there are ways to profit from it.
Perhaps most important to both stock and bond investors going forward is the trend in interest rates. Given the deep decline in rates since the recession began in mid-1990, many investors are convinced that we’re nearing the bottom. And if one assumes even a slight pickup in the economy next year . . . well, surely rates must rise sharply, right?
Not so, says Shearson Lehman Bros.’ global market strategist, Steven H. Nagourney. If we’re really replaying the ‘30s, he says, the surprise will be that interest rates will keep sliding even as the economy struggles to recover, and even as that recovery succeeds.
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While many investors believe that today’s yields of 6.5% to 8% on long-term (10- to 30-year) bonds are paltry, Nagourney sees those yields at 5% before this rate cycle is over. The clear message is that one can and should buy bonds now without fear.
“We have been focused so long on the business cycle as it looked in a period of inflation that we have forgotten some of the things that can happen during a business cycle that takes place with disinflation,” Nagourney argues.
Nagourney’s thesis derives from his study of interest rate cycles in the United States back to 1870. As the accompanying table shows, there were four major up and down “waves” in long-term rates between 1870 and 1981, each lasting 20 to 35 years, and each coinciding with an inflationary or deflationary cycle in the economy.
The last major up wave ended in 1981. For the past 11 years the trend in rates has been down.
Yet compared to the current annual inflation rate of 2.7%, bond yields still are extraordinarily high. Historically, bonds have paid 2 to 3 percentage points over inflation. Today, a 30-year Treasury bond yields 7.3%, or 4.6 points over inflation.
That’s why a further decline in long-term interest rates is necessary in America and abroad, Nagourney says: This down cycle in rates isn’t complete. Bonds’ inflation premium must be restored to traditional levels. Academics call it “reversion to the mean”--things always go back to normal.
What about the huge federal debt and all of the other sundry reasons why many investors fear that inflation, and thus interest rates, could zoom again?
In financial markets, fear and greed determine prices at any given moment, Nagourney notes. When people are afraid, they demand high interest rates to compensate. Once rates begin to come down, the psychology gradually changes to greed--investors become eager to lock in yields because they’re concerned that those great returns will never come again.
What’s more, once interest-rate and inflation psychology turns, it can become powerful enough to ultimately overcome the normal upward pressures that an economic recovery exerts on rates. That was the lesson of the 1930s, Nagourney says.
Contrary to what many Americans assume, the economy didn’t deteriorate year after year in the ‘30s. “Industrial production soared in 1933, faltered in 1934, then soared past its 1929 peak in 1936,” Nagourney notes. “The growth rate was faster than during the ‘roaring’ 1920s.”
In addition, “wholesale prices rose dramatically in 1933-’37 in line with the economic recovery,” he says.
But instead of rising with the economy, interest rates actually fell between 1933 and 1936, Nagourney says. Prime corporate bond yields dropped from 4.6% in 1932 to 3.1% in 1936. By the late 1930s they would drop to 2.7% as the economy weakened again.
Interest rates declined even in the face of the 1933-’36 economic recovery for one simple reason, Nagourney says: “Peoples’ expectations of inflation became non-existent.” Any price surges were viewed as temporary, once people got used to price cutting. (Does that ring a bell with airline passengers this year?)
Today, despite investors’ palpable unease, Nagourney believes that Americans are in the final stage of putting their 1970s-bred inflation demons to rest. Interest-rate cycles take many years to play out, he says, precisely because investors continue to fight the last war long after it ends.
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“They say that the underlying influence for almost everyone under 60 in today’s financial markets is inflation, since that’s where the most expensive lessons were learned--in other words, underestimating inflation” in the 1960s and ‘70s, Nagourney says.
But as low inflation continues in an economy where a mindset toward savings and investment replaces the consumption-crazy attitude of the ‘70s and ‘80s, investors should race each other into still-high bond yields, Nagourney says.
The Fifth Wave: A Long-Term Look at Interest Rates
There have been five major up and down waves in interest rates since 1870. Here’s a capsulization of each wave from the book “A History of Interest Rates” by Sidney Homer and Richard Sylla:
1870 to 1899: DOWN. The average yield on prime corporate bonds fell from 6% to 3.2%. The United States entered its first period of truly low long-term interest rates as the Civil War’s conclusion ended the nation’s need to pay high rates for foreign capital. Commodity prices fell as the nation expanded, and business investment in both the United States and Europe surged.
1899 to 1920: UP. Prime corporate bond yields rose from 3.2% to 5.6%. European rates led American rates higher, as commodity prices surged worldwide and speculation began to replace investment in many markets. Ever-recurrent threats of a currency shortage prompted creation of the Federal Reserve in 1914.
1920 to 1946: DOWN. Prime corporate bond yields fell from 5.6% to 2.4%. From 1920 to 1929, the nation enjoyed rising prosperity, except in agriculture. Commodity prices fell. And while private debt soared in the ‘20s, Americans saved enough to finance the debt and to fuel wild new speculation in the stock market. After the 1929 stock market crash and subsequent banking collapse, the economy sank and interest rates plunged further. Even with economic recovery from 1933-1936, rates continued to slide as investors sought to lock in bond yields in a low- or no-inflation environment.
1946 to 1981: UP. Prime corporate bond yields rose from 2.4% to 15.5%, with most of the surge occurring in the late 1970s. Interest rates rose only gradually in the 1950s and 1960s as the nation’s fast growth was financed by a high savings rate. By the 1970s, however, federal deficit financing, rocketing energy prices and rampant real estate speculation set the stage for a double-digit surge in inflation that nearly destroyed the bond market in the early ‘80s.
1981 to now: DOWN. Prime corporate bond yields have fallen from 15.5% to 7.3%. Inflation has tumbled as global business expansion has favored low-cost producers, slashing commodity prices. Real estate speculation has ended, and an aging population has increasingly flocked to stocks and long-term bonds for retirement savings.
