Tuesday, September 30, 2014

The Zero-Bound Myth (Musical Tribute)

The following chart shows the natural log of the 10-Year Treasury Yield.

Click to enlarge.

When using natural logs, constant exponential growth (or in this case, decay) can be seen as a straight line. As such, I have added a straight trend line in red. Note the very high 0.90 correlation. That's the declining path we're on (and we are currently right on it).

On the right scale, I show what the actual yield would be for a given natural log value. Note the declining yields over time. Also note that the scale (in blue) would never reach absolute zero no matter how far out I look. We simply approach it.

Unlike exponential growth, exponential decay can go on forever. There is no mathematical reason it cannot.

As seen in the chart, the 10-Year Treasury Yield as been exponentially decaying for more than 30 years. In theory, it can continue decay for many, many more years (just as it did in Japan after their housing bust in the early 1990s). In my opinion, those who argue that interest rates have nowhere to go but up over the long-term simply do not understand the process.

Let me describe the process by offering an example.

Borrow $100 at a 16% rate. You would pay $16 per year in interest.
Borrow $200 at an 8% rate. You would pay $16 per year in interest.
Borrow $400 at a 4% rate. You would pay $16 per year in interest.
Borrow $800 at a 2% rate. You would pay $16 per year in interest.
Borrow $1600 at a 1% rate. You would pay $16 per year in interest.

If your goal (or the Fed's goal) is to pay $16 per year in interest, then how much could you borrow at a 0% rate? An infinite amount! Those arguing that we're at our limit must not understand this. Zero is hardly a limit, as it would allow infinite leverage!

There are plenty of valid reasons to think that interest rates could rise, but The Zero-Bound Myth certainly isn't one of them. At 0%, an infinite amount of leverage could be applied, and infinity is a very, very big number.

So what does this mean? They can pry the long-term treasuries (mostly TIPS for inflation protection) and I-Bonds from my cold dead fingers. That's what. As I have stated many times on this blog, it is and has been growing increasingly difficult to make money off of money (exponentially decaying interest rates are not good for long-term savers). For what it is worth, I do not see that changing in my lifetime. I say this because I believe that our economy has been decaying over the long-term under what amounts to an illusion of prosperity. Decaying interest rates reflect that decay. What is the answer to every economic mishap? Declining interest rates! All eyes on the Fed!

The video is long. It will require patience to watch it. May it provide a calming moment in an age of instant satisfaction (think Mad Money and Fast Money).

Source Data:
St. Louis Fed: Custom Chart


jeff said...

Best guess - when did this "illusion" of prosperity commence?

In 1980s when yields peaked and bubbles became the norm. Or was it with the decoupling of the dollar from the gold standard and unconstrained private banking credit expansion? Etc.

jeff said...

Best guess - when did this "illusion" of prosperity commence?

In 1980s when yields peaked and bubbles became the norm. Or was it with the decoupling of the dollar from the gold standard and unconstrained private banking credit expansion? Etc.

Mr Slippery said...

I was persuaded of this long ago, and allocated accordingly. So far, so good.

Minor bone to pick with infinite leverage. Even if the interest is zero, you have to make principal payments and a declining median income will limit the amount of borrowing even at 0% interest.

Stagflationary Mark said...


Don't make me pick! I don't want to choose just one of your two choices, lol. Sigh.


Stagflationary Mark said...

Mr Slippery,

You can get a 2nd loan and use that money to make the principal payments on the first loan. Think like a bad business corporation constantly rolling over the debt to stay afloat!

Or, we can simply extend the duration of the loans. 2 year loans for groceries? 20 year loans for new cars? 100 year loans for new houses? The sky's the limit!

I say this somewhat tongue in cheek of course. Somewhat.

In all seriousness, anyone crazy enough to offer me a long-term 0% loan with no strings attached surely would be crazy enough to give me great terms on the payment plan. It's not like they are trying to make money off their investment.

Put another way, if the 10-year does hit 0% then I most certainly would not be a buyer. It would make more sense to just bury the cash. I therefore do not ever expect the 10-year to hit 0%. It might get closer to 0% than many think possible though, perhaps even myself.

Stagflationary Mark said...

As a side note, I have no desire to own junk bonds. I do want the principal back. I don't think the next recession will be kind to struggling companies. ZIRP is not a panacea. It is a symptom of the disease!

Nathan said...

I don't think investors realize that as interest rates have fallen so to has the ability to use liquidity as a proxy for (long-run) solvency.

For example, if you can make periodic interest payments of 8%, then you are providing a lot of evidence that your enterprise is solvent and you are generating surplus income. Furthermore, at 8% the effective burden of a principal repayment is relatively small since you've already provided a comparable sum in interest payments.

However, as rates tend towards zero the informational value of "can make payments" vanishes. You don't know the difference between a value creating and value destroying enterprise until principal is fully repaid. If the principle is rolled over, then the day of reckoning is further postponed. As Kyle Bass says, "a rolling loan gathers no loss".

This phenomenon isn't restricted to corporations, it applies to sovereigns, municipalities, and individuals.

For individuals, the 30-year mortgage has become a qualitatively different financial instrument over the last few decades. Anyone who took out a mortgage in 1980 either defaulted immediately or had substantial equity within a few years. Under these circumstances solvency is closely tied to liquidity and long-run solvency will be determined within a short timeframe. Even unsophisticated borrowers and lenders can make reasonable forecasts in this situation.

With mortgage rates at ~4.5% the relevant timeframe is much longer and forecasting becomes far more difficult. The real burden of the loan lasts much longer and being able to support a given payment today doesn't prove much about the future. There's also a much greater risk that a bad decision today (e.g. buying too much house) will have effects 20+ years into the future. If a 50 year old baby boomer takes out a mortgage today and makes scheduled payments they'll turn 65 still owing ~67% of the original balance (~50% in real dollars, assuming 2% inflation).

Does their 65-year old self really want to part with that much of their SS payment? Probably not, but with low rates there's no mechanism to discourage it from happening.

Stagflationary Mark said...


I absolutely agree that these falling interest rates for 30+ years have masked solvency issues.

I think your line of reasoning and commentary are sound.

Mr Slippery,

This also applies to what you wrote. Because principal repayment is part of the loans and falling rates do not eliminate or even reduce that part, one might argue that interest rates are way too high right now *and* it has become increasingly difficult to lower them sufficiently. In other words, there could easily come a point where subprime entities cannot get loans with favorable terms. I suspect we're getting very close again.