This is a Part 1, starting a series of articles: Why Interest Rates Would Stay Low No Matter What the Fed Says or Does.
Part 1: Why does Demography drive interest rates? Because it should
Let’s stir the pot: we forecast that the US Treasury 10 Year Yields would oscillate around 2.2% ±50 bps for many years to come. Bold, yeah?
Aging Demographics is the key driver behind low interest rates. The idea is not really new and is related to Modigliani’s Life cycle hypothesis. In the following series of articles we will examine and quantify from many angles why and by how much the 3 highly inter-related forces: Demographics, Deficit and Debt (government) would keep interest rates low for a long as an eye can see. Robert Arnott calls them “3-D Hurricane”. Or as Bill Dudley, the President of NY Fed noted:
“Demographic factors have played a role in restraining the recovery. As the population ages, this has two consequences. First, the spending decisions of the older age cohorts are less likely to be easily stimulated by monetary policy… because such age groups spend less of their incomes on consumer durables and housing. Second, as … the number of retiree’s climbs, the costs associated with Social Security, government pensions, and healthcare retirement benefits increase. This creates budgetary pressure and leads to a choice of raising revenue to fund these costs, cutting other government programs, or cutting benefits.”
But let’s check the facts first. In all consumer-driven economies the Demand for capital is driven by age-determined needs to finance durables: primarily, houses and cars. As the Figure 1 illustrates, mortgages dominate consumer debt. Obviously, most people buy their first home when they are young. In the US, consumers apply for a mortgage to finance their first house around the age of 28-32 (see the Figure 2):
Consumers also tend to apply for a car loan when they are young. Therefore, it is very natural to see that as Americans age their demand for capital wanes. Consumers do indeed grow their Debt levels mostly around the ages of 18-39, as the Figure 3 shows:
Conversely, the capital to younger generations (spenders) is provided by older generations (savers), who seek yields on their investments. See the Figure 4 above. When we have fewer young people, the demand for capital declines, while older people try to save and offer their savings for reinvestment (high yielding bonds, please!). And don’t forget, that once you get your mortgage, you immediately become a saver by starting to pay a portion of the principal on a monthly basis. Funnily, what we would call “old” or “older” here, is not that old at all! It is just that their consumption patterns mature as they shift more towards savings and more leisurely spending (we will discuss impact from retirees later).
In summary, Demography should determine demand for consumer Credit: ages 18-35 is the fastest period of growth for Consumer Credit, while consumers at Ages 40+ becomes recipients of Interest Income. The idea is that the aging demography indeed weakens demand/supply for credit. There is no way around it.
In the next Part 2 we will quantify via a simple regression why aging demographics foretells that Interest rates (US10Y) should stay around 2.2% several years out.
Stay tuned and please comment below!