The Interest Rate Cycle


Long-Term

In 2008 the United States saw the beginning of the worst recession in a generation. It all started when broke people who had been given mortgages at artificially low rates started to default because they couldn’t pay their bills. In response, governments and lending institutions lowered interest rates to stimulate the economy.

It worked but now we have a new problem. People are so obsessed with low interest rates that they have leveraged themselves to the point where even a modest increase in the cost of borrowing will cripple the economy beyond anything we have ever seen before, or at least in more than 3 generations.

Everyone likes to say that interest rates are at an all time low. But that’s not true. The chart above shows the prime lending rate in the United States all the way back to 1790.  The rates in Canada show a similar pattern.

The prime lending rate set by the bank of Canada back in the early spring is 2.85%. Contrary to popular belief that is not the lowest it has ever been. From February of 1944 to December of 1950 the Bank of Canada held the prime lending rate at 1.5%. For almost 6 years at the end of World War II credit was so cheap even an unemployed returning war veteran could afford to buy a house, and that was kind of the point.

My grandfather returned from the war in 1946 and bought a house in Oshawa Ontario for $3000. His mortgage payment was $36 per month. In 1950 interest rates started a steady climb and peaked in 1981 at 14.14%, mortgages at the time were going for an average of 21%.  Thankfully rates have been on a steady decrease ever since.

There are a lot of reasons why interest rates peaked in the early 80s. They rocketed up quickly in the late 70s due to instability in the Middle East, The Cold War, Jimmy Carter, you name it. But the fact of the matter is the rates had been climbing steadily for 25 years before Carter took office. Why was that?

In a word – Risk.

It’s kind of like the Peter Principle. That’s the management theory in which people are selected for jobs based on their past performance, rising through the ranks until they fail.

thepeterprinciple

Once someone fails in a position however it is very difficult to demote them so people tend to stay working at “the level of their incompetence.” If you apply this principle to interest rates people will tend to borrow money until they are no longer able to make the payments. When that happens they default so in order to keep the economy from stalling the government and lending institutions lower the interest rates and encourage more borrowing. But interest rates cannot go to zero so eventually we have to be okay with a few defaults and let the incompetent borrowers feel some pain, so we start raising the rates. As more people default we continue to raise rates so that the rest of us don’t lose our shirts on the money we have lent them through our retirement accounts and stock portfolios.

That’s what started to happen in 1950. The risk of keeping interest rates low started to catch up as too many people who couldn’t afford to borrow money started to mount up too much debt.  It took the next 30 years before we reached the peak when no one could afford to borrow money. Well it’s been another 30 years and here we are, with interest rates hovering back around 2%. What do you think is going to happen next?

I’ve said it before and I’ll say it again.  Get out of debt while you still can so that when rates inevitably begin to rise you will be on the receiving end of the increased returns instead of paying more to keep that house you know you can’t afford.

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