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Something to Think About #80: Interest Rates: Direction by – Klarise Yahya

Posted on 01. May, 2019 by in all, Magazine Articles

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Continued from Part 79 . . . Beneficial Beneficial deflation reveals itself
through price declines, either generally (the Second Industrial Revolution) or
specifically (e.g., ever-lowering prices for computer memory). Deflation is
thought by Those-Who-Consider-Such-Things to be disastrous to the economy.
History shows that it doesn’t have to be. Once past the awkward transitional
period when mule-skinners learn to be locomotive engineers, the lowering of
prices, whether general or specific, results in higher living standards for nearly

In both examples of beneficial deflation the key element was an active credit
market stable enough to encourage long term planning. Sound planning led to
production efficiencies, which in turn provided for increased supply. As supply
grew, competitive demand pressures drove the lowering of prices, and this
resulted in more sales, which in turn generated higher employment and more tax
revenue. Overall, beneficial deflation is a Very Good Thing.
Dreadful : But sometimes the credit market is non-supportive and things turn out
quite differently, occasionally all the way to dreadful. In extremis, the credit
markets fail the economy and the result can be a deflationary spiral. Escape is
painful. A deflationary spiral is “a downward price reaction to an economic
crisis leading to lower production, lower employment, decreased demand and still
lower prices.” It’s a type of uroboros, where the economic dragon consumes its
own tail through less investment borrowing, lower production, and decreased
sales. Both employment and tax revenues sink. In these ways a dreadful deflation
is the reverse of what we saw in the two examples of beneficial price lowering.
The economic cycle is defined by interest rates. A lowering of interest rates in the
back half of one cycle is followed by their subsequent rising in the first half of the
next rate cycle. The good part comes first: stimulative low rates drive investment
prices higher. Investment owners are happy and buyers are hopeful.
But when interest rates get a cold, asset prices get pneumonia. To illustrate, if
rates were 8% and a prospective purchaser could afford a monthly home payment
of $500, he would be able to service a $68,000 debt over 30 years. But if rates
became stimulative and incrementally ratcheted down, to say 2%, that same $500
house payment would service a much higher debt of $135,000. Nothing changed
except the timing: the point on the interest rate cycle when the loan was made.
When rates are low, prices are high. When rates are high, prices are low.

Rates predictably reverting from low levels to (or above) their mean can drive
payments on variable debt to unaffordable levels. Ever-larger monthly payments
to service debt on things already owned threatens repossession / foreclosure and
resale of consumer items at bottomless sale prices. Unlike new items which have a
price floor (the sunk costs of capital, materials, labor, shipping, taxes, etc), used
items have no price bottom. The sunk costs were recovered at the original sale.
The used item now has no theoretical bottom, as buyers of “short-sale”
properties during the Great Recession (2007 – 2009) can attest. As an example,
Forbes Magazine (Dec, 2010) referenced Florida condominiums in West Palm
Beach and Boca Raton going for as little as $8,500.
In a “bad” deflationary period, costly new goods must compete directly with pre-
owned items, generally to the detriment of the expensive new goods. The results
are closed businesses, unemployment, repossessions, and foreclosures. Examples
of economies giggling their way through the shadows are America’s Great
Depression (1929 – 1939), Hong Kong (1997– 2004), and Japan (begin: 1989).
The collapse of an advanced economy’s debt-bubble and subsequent consumer-
induced deflation has happened many times before. Dreadful deflation is part of
the long term credit cycle. It is where (now) unaffordable debt goes to die. It can
and will happen again, but it can be managed: deflation is a timing issue.
These articles have discussed, over the past year, several of the constituents of
value. These have included not only the Secular Rate Cycle, but also Scarcity,
Diversification, Having a System, Location, Risk, Inflation, and Deflation.
The idea being that investing is a systematic process and recognizing the
constituents might make it easier to perceive the underlying system: see the
pieces, observe the whole. It works the other way too: observe the whole, seek the
elements. The conclusion in both cases is a recognizable system of investment
composed of certain common parts.
This article will provide a way to compare the current 10-year Treasury rate with
its historically average rate. This illustrates the probable trend of future rates. An
early indicator like this can be useful. The movement of interest rates (either up or
down) affect asset values both directly (ex: mortgages) or indirectly (ex:

Two measures of economic value are (a) net income and (b) capitalization rate.
Everything else being the same, values increase when net income increases. An
investor will pay more for a big stream of net income than for a small one.
If a given stream of income is capitalized at a high rate, the resulting value will be
lower. The capitalization rate is the inverse of value: a low rate of capitalization
generates a higher value and a high cap rate yields a lower value. Formula: Net
Income divided by Cap Rate (in decimals) equals Value.

Results will be affected by sample size and also by the relevance of the data set. .

Sample Size: When determining the mean weight of dogs, it is not good science
to weigh only Pipi, the Bichon Frise, and Magnus, the English Mastiff, and
conclude that the average weight of all dogs is 110 pounds. Two samples from a
population are not enough to generate a reasonable confidence level.
When determining the mean, the larger the number of data points, the better. This
article will use historical interest rates from 1968 to 2018, but the result is not
written in stone. Having a smaller sample, or picking different start / end dates
would generate a different number.
Relevance: The relevance of the population is important. “Population” is the total
set of observations that can be made. In the example of Pipi and Magnus, the
population would be every dog in the world, but in most cases the data set is
simply a representative sample of the subject population. It is not always
necessary to weight every dog in the world.
The 10-year Treasury issue is the most liquid and widely traded bond in the
world, and thus a good mirror of the economy at any given point in time. It is the
benchmark index for most large debt (including mortgages). Debt, as an asset
class, is so large that the weight of the market has settled into a sort of Nash
Equilibrium (def: a stable state where a unilateral change can benefit no player if
the other players do not change their strategy) reflected by the yield on the 10-
year Treasury note. It represents the “risk-free” rate at any given moment.
Drawing from 10-year Treasury historical data generates a sample set that is both
relevant and sufficiently large that reasonably informed conclusions can be
Overshooting : There’s a critically important corollary to the principle of
Reversion Towards the Mean (discussed below): overshoots. Things revert
“towards” the mean, and often past it. Whether rising or falling, prices usually
continue past their long term mean, sometimes well past. Then they again reach
unsustainable levels (whether on the upside or the downside). At this point they
turn around and again approach their Long Term Mean, but from the other side.
The wise investor should keep “overshoot” in mind when refinancing or buying.
When?: The secular interest rate cycle stretches over decades, and sometimes
generations. It is long enough that some (most?) people might experience the
complete cycle only once in their investment career. For the investor, the critical
moments in the secular interest rate cycle are the turning points, the peak and the
bottom. If precautions are taken in a timely manner, investments may float upon
an ever-rising tide for a generation or more. Witness the farsighted people who
were prepared to buy income properties just after mortgage rates peaked at
18.63% in October, 1981. Everyone knows what happened to asset values as rates
declined for three decades.
It is not possible to know when the cycle peaks (or bottoms) until hindsight
whispers, “Shucks, Priscilla! You should have done it last year!”, but it is
possible to judge the plausibility of change. Some signals present a greater
likelihood of a secular turning point than others. One important signal is the
interest rate. Peak interest rates are followed by declining rates. Alternatively,
token mortgage rates (ex: 3.31% in 2012) presage climbing rates.

In the long haul, we know these secular inflection points have occurred in the past
and will eventually occur again. But we don’t know when. We might recognize a
period when conditions appear to be ripe, but there is no way we can know with
certainty the near-term path of interest rates. In the short term, things are random.
In the long term, things revert towards their mean.
One way to handle this uncertainty would be to prepare for an anticipated future
change, but to not act until the changes have been confirmed.

Determining the Mean

The mean is the statistical determination of “average”. The mean of 10+10+30 is
16.67. That is also the average. Both words refer to the same result, but with a
small difference. Generally, “average” is used to imply a WAG (Wild Alcoholic
Guess), while “mean” suggests a calculator was involved.
In this case, a cheap calculator was used to add the annualized rates of 10-year
Treasuries during the 50 years prior to 2018. The sum was then divided by the
number of data points taken (50), and it was found that the mean interest rate over
the past half-century for 10-year Treasuries was 6.27%.
This data point can inform the (a) refinance, (b) purchase, and (c) sale decisions.
Standard Deviation
The standard deviation (SD) is a measure of central tendency. One SD contains
68% of the measurements, half on the left side of the mean and half on the right
Between 1968 and 2018 the standard deviation of the 10-year Treasury was 2.98,
indicating that 68% of the time rates ranged from 3.29% to 9.25%.
This becomes important when evaluating the risk of a variable rate loan.
Reversion Towards the Mean
It is necessary to know the Long Term Mean to develop future interest rate trends.
An appropriate data set causes the mean to become sufficiently robust that
prediction of the trend in future interest rates become viable. Current rates above
the mean will eventually fall, and rates below the mean will rise, over time, and
trend upwards towards the mean.
Mortgage rates consist of the sum of (a) the index and (b) the margin. The margin
is determined by the lender, and is the fixed rate portion of the total interest rate,
generally somewhere between 2.5% and 3.0% depending on the lender and the
loan’s perceived risk.
The index, often the 10-year Treasury, adjusts either up or down as the market
breathes. Using the 50 year average rate for the 10-year Treasury note index,
mortgage rates should now be much higher than they are. The average long term
index rate of 6.27% plus a margin of 2.75% add up to 9.02%.

To put this into perspective, on the day this was written the 10-year Treasury was
yielding 2.41%. Adding a typical margin, the expected interest rate on a loan
written today would be 5.16%.
Income property prices now reflect a 5.16% underlying interest rate. This
conflicts with the normalized rate of 9.02%. If mortgage rates were at their fifty
year average today’s rates would be 75% higher than they are. An example of that
would be a hypothetical variable rate mortgage currently at 4.75% being repriced
at 8.3%. Such an increase in mortgage rates can be expected to have a meaningful
effect on values.


Historical data indicates asset values are teetering on the edge of a precipice.
Eventually they will fall (and again, we don’t know when). But although rates are
not as low as they recently were, they are still below their long-term average. This
is the time for a thoughtful investor to lock in a favorable refi at (still) historically
low rates.
This article is for informational purposes only and is not intended as professional
advice. For specific circumstances, please contact an appropriately licensed
professional. Klarise Yahya is a Commercial Mortgage Broker specializing in
difficult-to-place mortgages for any kind of property. If you are thinking of
refinancing or purchasing real estate Klarise Yahya can help. For a
complimentary mortgage analysis, please call her at (818) 414-7830 or email

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