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Why do interest rates matter?
You may be wondering after last week’s dramatic fall in the stock market, why do interest rates have such a profound effect on the value of stocks?
And why is it that seemingly small changes in interest rates have such outsized effects on the value of stocks?
The reason has to do with two things, that can each be though as interest rates:
- The Risk-Free Rate, and…
- Return on Investment above and beyond the risk-free rate
The risk free rate is the rate of return on US Treasury bills.
The term “risk-free” implies that there is no risk in owning/investing in US Treasury Bills. Could this be possible, that there is no risk in US Treasury Bills?
Yes, and no.
The US government has never defaulted on its debt. If we use just this fact, it would imply there is no risk in owning US government debt. The US government sells US Treasury Bills and US Treasury Bonds to fund its debt and day to day operations. US Treasury Bills are different from US Treasury Bonds, which are also different from US Treasury Notes.
- US Treasury Bills are short-term loans taken out by the US government. There are several durations of loans that are considered Treasury Bills.
- 1 month
- 3 Month
- 6 month
- 12 month
- US Treasury Notes are medium term loans taken out by the US government. There are several durations of loans that are considered Treasury Notes.
- 2 Years
- 3 Years
- 5 Years
- 7 Years
- 10 Years
- US Treasury Bonds are long term loans taken out by the US Government. There is one duration
- 30 Years
When the government takes out a loan, it becomes a debtor. The counterparty, the creditor, is the investor. A metaphor for the government in this scenario is a homebuyer who takes out a mortgage, from a bank, the creditor. The market for US government debt is an international market; foreign and domestic investors borrow money to the US government via the debt markets.
WAR BONDS
War Bonds were issued during World War II to help the government finance the war. Average US citizens bought war bonds, thereby investing in the war effort. In return, the government paid back its investors after 10 years, plus interest. That interest rate was 2.89%.
World War II was a time of economic prosperity. The war unleashed America’s industrial might, and created the military industrial complex that is still responsible for a large portion of America’s economic output.
The below visual aid from OurWorldInData.org shows exactly how much military spending occurred during World War II. The US spent over $700 Billion [in constant year 2000 USD value] fighting World War II, almost double the amount spent by Nazi Germany. In constant year 2011 US Dollars, the US spent $4.1 Trillion, according to a piece by the Federation of American Scientists. In World War II era Dollars, the US spent $296 Billion. Notice that at the peak of World War II, the US was spending 37.5% of GDP on defense! In comparison, peak defense spending in the post-9/11 world was 4.3% of GDP. World War II truly stands alone in this regard, and will hopefully never be exceeded.
The table below, with data from the US government budget office (OMB), shows how much each of the wars fought by the United States cost, in both actual dollars, and adjusted 2011 US Dollars.
| Total Cost of War, in Billions USD | Inflation Adjusted Cost, in FY 2011 Billions USD | % of GDP @ Peak War Cost | |
| War of 1812 | 0.09 | 1.55 | 2.2% |
| Mexican War | 0.07 | 2.38 | 1.4% |
| Civil War: Union | 3.18 | 59.63 | 11.3% |
| Civil War: Confederacy | 1.0 | 20.11 | N/A |
| Spanish American War | 0.28 | 9.03 | 1.1% |
| World War I | 20.0 | 334.0 | 13.6% |
| World War II | 296.0 | 4104.0 | 35.8% |
| Korean War | 30.0 | 341.0 | 4.2% |
| Vietnam War | 111.0 | 738.0 | 2.3% |
| Persian Gulf War | 61.0 | 102.0 | 0.3% |
| Iraq War | 715.0 | 784.0 | 1.0% |
| Afghanistan War | 297.0 | 321.0 | 0.7% |
| Total Post-9/11, Iraq,Afghanistan,Other | 1046.0 | 1147.0 | 1.2% |
Another interesting graphic, also from OurWorldInData.org, shows that as a % of GDP, US military spending has been declining rapidly, ever since the end of the Cold War, despite an increase post-9/11.
That increase in spending ended in 2010. In 2016, military spending was 3.29% of GDP. It’s possible, and likely, that President Trump’s budget will increase defense spending, as is usually the case on Republican administrations, but we don’t have the data yet.
Notice that Russia, led by Vladimir Putin, has dramatically increased defense spending, relative to GDP.
One explanation for that may be that Russian GDP is contracting. Turns out, this is exactly the case, as we can see below. Starting in Q4 2014, Russian GDP contracted for 8 straight quarters! Interestingly enough, Russian intervention in the Syrian Civil War began in September 2015 (Q3 2015).
Notice from the above that Russian intervention began when the Russian economy was contracting most severely, at a rate of -2.5% year over year.
We know from political and military history that autocrats will often start wars when their economies are in bad shape, as a way of deflecting popular attention from the economic hardship, to patriotic duty to support nation over self. It’s called the Diversionary Theory of War.
The annexation of Crimea in March 2014, and the Russian involvement in the Ukrainian Civil War in February 2014, both coincide to the same period of severe economic contraction in Russia.
The total amount of war bonds sold (by the US government) and bought (by Americans) during the second world war was $187.5 Billion! That number is clear evidence of the strong commitment the US public had toward the war. Recall the total cost of the war in actual dollars was $287 Billion. That means 65% of the war was financed by either the personal savings of US citizens, or the earnings of US business.
Very impressive to say the least.
If the US had not won the war, an investment in War Bonds would have most likely been a total loss. The reason being much of the cost of the war was loans to US allies. If Nazi Germany had won the war, those loans would have never been repaid, and the US government would have most likely defaulted on its debt.
War bonds were sold to the public at a 25% discount to face value. This means that if someone wanted to buy $1,000 worth of war bonds, they would pay up-front $750 to the government. After 10 Years, which was the duration of the war bonds, the investor received the $1,000 face value of the bond, amounting to a profit of $250.
At face value, one would think the RIO (return on investment) of a World War II war bond was 3.3% per year, since a $750 investment yielded $250 after 10 years. In actuality, we have to convert the yield into an annual yield, in order to compare it to other bond investments. We have to discover the Yield to Maturity on the War Bond. We do this by taking into consideration, the compounding effect of interest.
The formula for calculating the Yield to Maturity of a zero-coupon bond is below. A zero coupon bond is one that does not make interest payments. It simply sells for a discount, and then pays out a full face value sometime in the future. War Bonds were Zero Coupon Bonds.
The yield on War Bonds was pegged at 2.89%. Pegged means the government artificially determined the price of interest on the loans, without consideration for the market for interest rates.
The reason why the government pegged the interest rate at 2.89%, despite the fact that inflation and GDP growth was much higher than that, is because the US government wanted to limit the amount of interest it would have to pay once the bond came due. This was done because the war had an uncertain outcome, which meant the fate of the country was at stake. Interest debt on the loans was the last thing the government wanted to worry about.
Cost was a large factor in the decision to drop the Atomic Bombs on Hiroshima and Nagasaki. Government debt had already soared during World War II, and the deficit was at 26.8% of GDP in 1943. You can see from the chart below, not even today, with the national debt at $22 Trillion, is the deficit that large (relative to GDP).
As we will see in a bit, inflation was a worry in the US during the war. So much of production and supplies was being diverted to the military. Everything from food and clothing to cars and stoves became scarce. The US government was forced to put price controls on stuff, to keep prices down, artificially.
A side-effect of this was to make investing in War Bonds more desirable. Why you ask? Because when prices are kept down artificially, the free market can’t work. Consumers and producers can’t determine supply and demand, and at what price the two meet. Investing is stifled when prices are controlled by the government; think Communism. As a result, money was further diverted, even forced, into War Bonds.
The Federal Reserve’s History website has a piece on the role it played during World War II. An excerpt from that piece:
“To keep the costs of the war reasonable, the Treasury asked the Federal Reserve to peg interest rates at low levels. The Reserve Banks agreed to purchase Treasury bills at an interest rate of three-eighths of a percent per year, substantially below the typical peacetime rate of 2 to 4 percent. The interest-rate peg became effective in July 1942 and lasted through June 1947. The Reserve Banks reduced their discount rate to 1 percent and created a preferential rate of one-half percent for loans secured by short-term government obligations, substantially below the 3 to 7 percent that had been common during the 1920s. All of the Reserve Banks implemented these rates in the spring of 1942. The rates remained in effect until January 1948.”
Pegging interest rates should sound familiar to anyone who knows anything about the post Great Recession US economy. The Federal Reserve has artificially controlled interest rates ever since 2009. It did this via its Quantitative Easing program.
Quantitative Easing essentially put a ceiling on how high interest rates could go. The Federal Reserve was given the authority by the US Government to print US Dollars, and use those US Dollars to buy US Treasury bonds from the market. Notice the Federal Reserve also did this during World War II. In exchange, holders of those bonds would get cash. By buying these US Treasury bonds (and also government backed mortgage bonds), the Federal Reserve kept interest rates low along the desired part of the yield curve, specifically the part it had least control over via its traditional interest rate tool: the Federal Funds Target Rate.
The Federal Funds Target rate has the most influence on US Treasury Bills, and other short term maturities of US Treasury Notes (2, 3, 5 year). In order to bring down long term interest rates, to make it cheap to invest money in risky long-term assets (real estate, business investment, infrastructure investments, etc..), Quantitative Easing was put in place.
In the case of War Bonds, the US government pegged rates for a slightly different reason; they wanted to actually prohibit investment, not encourage it. The reason why it worked to prohibit investment is because REAL interest rates were much higher than 2.89%.
We know this because inflation data, and GDP growth data, shows that nobody in their right mind would have normally invested in something yielding 2.89% if the inflation rate was closer to 8% and economic growth was booming at 6.9%.
| Inflation Indicator | Avg Yearly % Change, 1939-1948 |
| Wholesale Prices | +8.2% |
| Implicit Price Deflator | +6.5% |
| Money Stock | +12.3% |
| Money Income | +10.7% |
| Real Income | +4.2% |
| Economic Growth Indicator | Avg Yearly % Change, 1939-1948 |
| Growth Domestic Product (GDP) | +6.9% |
An investment yielding 2.89% would actually have a negative real yield if inflation is greater than 2.89%. To understand this concept, think of your savings account, where you’re probably getting an interest rate of 0.1%. If inflation is 2%, every dollar you have in your savings account is buying you 1.9% less stuff every year you leave it there.
You might ask, why didn’t people buy stocks instead of War Bonds, if economic growth and inflation were so high? The stock market reflects inflation and growth. There technically was an alternative over War Bonds. This is true, but recall, the US had just emerged from the Great Depression. Americans suffered from PTSD as a result of the Great Depression. Many lost everything in the stock market. That psychology, that trauma, combined with a lack of trust in the capital markets, was a powerful force that drove more Americans to buy even more War Bonds.