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Understanding Interest Rates

This week we experienced another interest rate increase. How did we get here and where are we going? Let’s dive a bit deeper into this topic.

How did interest rates get this low?

Interest rates have been rather low for quite some time. This has happened before and will happen again. But it’s not easy to get to such an extreme level. The six factors that contributed to such low levels are:

  • Seriously slow economic growth (over the last 20 years)

  • Lack of attractive investment opportunities for businesses (they can’t find anything worthwhile to invest in)

  • Monetary stimulus by the Federal Reserve (they’ve been printing money)

  • Collapsing international trade

  • Falling inflation (until just recently)

  • People are losing money every year after adjustment for taxes and inflation

What happens to interest rates next?

They go up... a lot. And this rise is not expected to happen over 2, 3 or 4 years but instead over 2, 3 or 4 decades. Such an outcome is not the exception, instead it’s historically commonplace and normal. If interest rates were to rise for just a year, or two, or three that would be abnormal and inconsistent with history. Interest rates will not rise every year. We will experience wiggles along the way.

Why is it necessary that interest rates rise?

Negative interest rates can last for quite a few years, but not indefinitely. When you lend money, you:

  • Give up the use of that money

  • Experience illiquidity

  • Expose yourself to various risks (e.g., default, inflation, interest rate, currency)

Lenders require a large enough return to fully offset these three disadvantages. Eventually, they will stop lending money until such time as interest rates rise sufficiently to return a fair return.

What’s normal for interest rates - what’s always happened throughout history?

They rise or fall by 12% to 13% over 25-year periods. The following graphic shows the history of interest rates after adjustment for inflation.

Two- to three-decade long cycles of rising or falling interest rates is the norm.

What would be abnormal?

For example, in May, the 10-year Treasury yield was at 2.8% . . . which after taxes and inflation is losing -1.2% per year, every year, for ten years. Such an outcome is not sustainable. Equally abnormal would be for interest rates to fail to overshoot, they always have in the past. In other words, they always rise too high and similarly fall too low.

In conclusion

Interest rates (after adjustment for inflation) have been falling since early 1984. But now we’ve embarked on what is likely to be a multi-decade long era of rising interest rates. Remember... this is normal, stay the course and opportunity awaits.

Do you have questions about rising interest rates and how this may impact you? Click the button below to schedule a call with me.

All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Integrated Financial Partners, a registered investment advisor and separate entity from LPL Financial.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.


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