$tarrBuck Report for November 5, 2006: The Future of Interest Rates and the One-Armed Economist

November 5, 2006

$tarrBuck Report for November 5, 2006:  The Future of Interest Rates and the One-Armed Economist

by R. M. Starr

“Give me a one-armed economist,” President Harry S. Truman once demanded as he vented his frustration over economic advisers who offer recommendations, then hedge their bets by tacking on a slew of caveats, often beginning with the phrase “but, on the other hand…”

Economists agree on the demography of industrial countries in the first half of the twenty-first century.   High birth rates in Germany and Japan in the 1930s, in France in the 1940s,  USA late 1940s – mid 1960s, followed by declining fertility throughout the rest of twentieth century, mean that the twenty-first century will be typified by aging populations, increasing proportions of the population retired, a declining portion of the population of working age.

That leads to three inescapable conclusions:  Long term interest rates will fall /or rise /or remain without trend over the course of the twenty-first century.

The case for rising interest rates
Middle-aged people work and save.  Retirees spend and draw down their wealth, selling off capital.  Governments provide old-age pensions (Social Security) financed by floating debt.  As the population ages, typical saving and investment patterns move from net saving to dissaving, drawing down savings for retirement.  The pool of savings shrinks, driving up interest rates.  Assets are sold, driving asset prices down, yields up.

The case for falling interest rates
A growing population of retirees means a shrinking work force.  As the work-force shrinks, the amount of capital per worker expands.  An abundance of capital drives down the yield on capital, bringing real interest rates down.

The case for don’t know
Capital markets are international.  Goods and service markets are increasingly international (remember outsourcing).  Economic expansion in high-saving countries (e.g. mainland China) and growing world trade mean an expanding pool of savings (keeping interest rates low) and increasing labor productivity (keeping the yield on capital high).

What does this mean for individual investors?
Rising interest rates:  keep maturities short.  Long term bonds go down in value.  Common stock and real estate values will decline.
Falling interest rates:  Invest in long maturities now.  The yield on short term savings will decline, making it hard to fund retirement.  Real estate and stock values will increase.
Uncertain trend:  Don’t put all your eggs in one basket.  Diversify across maturities, real estate, common stock, internationally.

And definitely, look for a one-armed economist.

(c) R. M. Starr, 2006

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