Interest: The Reward And Risk Of Time

Few concepts are as fundamental and powerful as interest. Widely recognized as the bedrock of economic growth and wealth accumulation, interest is a force that shapes our financial decisions and long-term prospects. But at its core, interest embodies the paradox of being a reward and a risk—a duality that underscores its significance.

Why Is Understanding Interest So Important?

Interest serves a fundamental purpose in the world economy. It provides capital to those borrowing money while generating income for the savers who lend the money. As such, interest is both the reward for saving and the cost of borrowing. This dichotomy works to discourage investors and lenders alike from taking excessive risks.

In 1898, Swedish economist Knut Wicksell introduced the concept of the “natural interest rate” (subsequently referred to as the “neutral rate”). It is a rate that balances the supply of savings with the demand for investment. When the actual rate aligns with the neutral rate, economic stability prevails: neither slowing nor accelerating the economy. Deviations from this equilibrium, however, can lead to disruptions such as an overheated economy or sluggish growth.

The Balancing Act

Interest works as a balancing scale: the give and take; the yin and yang of the financial markets.

On one side of the scale, we have the concept of reward—interest as the "give." This is the side where time's magic unfolds, compounding wealth. As money is invested and nurtured over time, compound interest creates a snowball effect of accumulating wealth.

On the other side of the scale, we have the notion of risk—interest as the "take." This is the side that reminds us of the dynamic nature of financial markets and the unpredictability of the future. Investments can rise and fall, economic conditions can shift, and compounding interest expense can significantly increase an asset’s cost.

A Key Economic Driver

The give-and-take dynamic of interest extends beyond individuals to the broader financial ecosystem. Central banks regulate interest rates to influence economic activity, balancing borrowing costs and inflation. This macroeconomic give-and-take can impact consumers' financial choices, shaping our ability to save, invest, or spend.

Just like the balancing forces of yin and yang seek equilibrium, interest strives to find its balance between these two sides.

The problem is that the neutral interest rate cannot be observed and pinpointed directly. Rather policymakers and economists infer the rate with hindsight and by watching and modeling current economic activity.

When this delicate balance gets out of kilter, when interest rates are set too low or too high, rational behavior can falter (and irrational behavior can grow exponentially).

Remembering The Global Financial Crisis

The concept is intuitively simple. But financial markets are anything but simple. Recall the global financial crisis of 2008-09. Lenders were loaning money indiscriminately; borrowers’ appetite for highly leveraged risky assets was insatiable; and investors had lost sight of the fact that failure was an option. Then the bottom fell out of the real estate market dragging the stock market down with it.

The Federal Reserve along with central banks around the globe responded by dropping interest rates to near zero. Savers were punished (earning nothing on their savings) in favor of borrowers who began grabbing low-cost debt by the bucket load.

Depressing the interest rate is a powerful tool to fend off a recession, but it can also have profound knock-on effects.

Savers had little choice but to abandon traditional fixed income assets in search of higher returns in more aggressive assets (e.g., stocks, real estate, alternative investments). Liquidity and ‘cheap’ leverage have fueled the financial markets since the crisis, pushing asset valuations higher for more than a decade.

When asset prices are rising, people and companies feel emboldened to borrow to support spending and investing. Strong equity markets can make the temptation to take on more leverage irresistible. Wall Street loves to use other people’s money and likes to pay as little as possible for the privilege.

Where do we stand now?

Year to date the S&P 500 Index is up 16% while the tech-heavy Nasdaq Composite has soared 28%. That is the best start to a year since 1997.

In the second quarter of 2023, US credit card debt surpassed $1 trillion for the first time ever while at the same time, average interest rates on those cards are again reaching historic highs of around 21%.

When we look at the flip side of the spending coin, the personal savings rate (which since 1960 has averaged 8.8% of disposable income) is getting close to an all-time low. For the 12 months ended June 2023, the saving rate was 3.8%, less than half the long-term average.

The Fed has its finger on the scale

Now, after 15 years of historically low interest rates, we find ourselves amid a dramatically shifting financial backdrop. Since March 2022 the Fed has been raising interests from near zero to more than 5% today.

Fixed income returns have been steadily rising. Money market funds are delivering 5% or more—yield levels not seen since 2007. Inflation has come down from its peak but remains stubbornly high. Home mortgage rates have returned to pre-financial crisis levels.

After a sharp decline in 2022, stock valuations have rebounded strongly. As of the closing bell on August 23rd, the S&P 500's Shiller P/E ratio was 30.6. Not only is this well above its average reading of 17 going back to 1872, but it marks only the fifth time in the last 25 years that the Shiller P/E has exceeded 30 during a rising market. The previous four instances where the Shiller P/E ratio surpassed 30 eventually led to declines of at least 20%.

Standing On A Razor’s Edge

"Eventually," however, can be a long time coming. I don’t pretend to know the short-term direction of the stock market, but the combination of high yielding fixed income, more expensive leverage, and elevated asset valuations implies to me that we could be in for a bumpy ride. Buckle up and stick to your long-term financial plan.

By embracing both sides of the interest scale and appreciating the delicate balance they create, we can learn to make better informed decisions and keep our footing as the financial landscape shifts beneath us.

As the adage goes: Those who understand interest, earn it. Those who don’t, pay it.

As always, invest often and wisely. Thank you for reading.

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The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.