Interest rates have always been a topic of concern and questions from clients, particularly over the past 10 years. As we came out of the global financial crisis in 2009, some worried that actions taken by the US and overseas governments, intended to encourage bank lending and speed a recovery, would trigger inflation and higher interest rates. Instead, rates have remained low and fallen farther still. Why?
Interest rates are influenced by many things, and in the US the most obvious are the actions taken by the Federal Reserve (Fed). The Fed controls three tools of monetary policy to influence the availability and cost of money and credit: open market operations, the discount rate and reserve requirements. But the interest we earn on our savings account and bond funds, and the rate we pay on our mortgage, are all influenced by more than the Fed.
During the last years of Alan Greenspan’s term as the Fed Chair ending in 2006, the Fed raised short-term rates repeatedly, but even with these rate increases longer-term rates remained persistently low. Some felt it was due to global flows of savings and investment, with China and other emerging market economies investing in safer US bonds. If more people want to invest in the same bonds, the rate of interest an issuer must pay to attract buyers can remain low and drop lower still if people are willing to purchase them.
Persistently low interest rates in the mid-2000’s encouraged higher real estate prices and drove real estate mortgage activity. These mortgages were packaged into new investment products like CMOs that were sold as higher-rate, risk-equivalent alternatives to traditional corporate bonds. Then the real estate bubble burst and mortgages loans inside CMOs and similar investments defaulted, causing credit markets to lock up, triggering the global financial crisis.
As history has shown, when investors are afraid of the future, they tend to invest in things they feel are safer – like bonds, money market funds, CDs and savings accounts. Demand for these investments after the stock market drop between October 2007 and the recovery that began March 2009 kept interest rates at low levels. While the Fed took action to stimulate the economy and central banks in Europe eventually did the same, the economic recovery remained slow, even though stock markets recovered.
Interest rates in Europe were negative by 2014, with the European Central Bank (ECB) setting rates in September 2019 to a record low of -.5%, creating a unique set of challenges for savers and banks. But by February 2020 the US economy seemed to be recovering, with unemployment at 3.5%, and the talk of potential wage-driven inflation began again. Then COVID-19 hit the globe.
In March 2020 the Fed reduced the reserve requirement for banks to zero, and in September indicated they expect to leave interest rates near zero for years – through at least 2023 – in order to stimulate the US economy. More significantly, in the past the Fed would increase rates as unemployment dropped and inflation was expected to increase, but Fed Chairman Powell said they will now wait until inflation has risen to 2% and is on track to exceed that amount for some time before considering a rate increase, to allow real inflation to take hold before restraining it.
Central banks like the Fed and the ECB can work to manage rates, but investors and their feelings about current events and their beliefs about the future are the ultimate drivers of interest rates.
So, what do low interest rates mean for us as investors? There are benefits as well as potential risks:
- Lower mortgage rates for homeowners and lower interest rates on car loans and student debt increase our cash flow. A home is usually the largest purchase an individual makes over their lifetime, and low rates mean significant savings that can go toward other goals like saving for college tuition or retirement. When we bought our first home in 1985, 30-year fixed mortgage rates were at 13%. Last summer our son and daughter-in-law bought their first home and their 3% mortgage allowed them to purchase a similar home with a monthly mortgage payment equal to 1/3 what ours would have been.
- Lower rates tend to stimulate economic activity and encourage businesses to make capital improvements. Here at TAAG, we’ve made improvements to our office building to make the workspace more efficient and our entrance more welcoming.
- Lower rates help increase the value of businesses and the price of stocks. Acquisition-minded companies are more likely to pay a higher price for a company if they can borrow capital at lower rates. Publicly traded stocks become more attractive to investors because they offer dividend yields that are competitive when compared to bonds.
But low interest rates can create risks as well:
- Low rates can encourage excess borrowing and higher debt, leading to over-leveraged consumers and businesses that are vulnerable to downturns in economic cycles and interest rate increases.
- Low rates are difficult for savers who rely on interest to meet their income needs and can cause investors to take on more and more risk looking for higher yielding investments, like the CMOs that helped trigger the global financial crisis.
- Persistently low interest rates could lead to a deflationary economy like the one Japan has experienced over the last 20 years, leading to stagnant wages and slower economic growth.
As vaccinations for COVID-19 roll out across the US and the rest of the world, and we are able to gather in large numbers again, there is a possibility that consumers will create a wave of stimulus as travel resumes between countries, restaurants can operate at full capacity, and other opportunities to spend are available. This could drive inflation, lower unemployment, and raise interest rates sooner than we expect. But given all that has happened in our world over the last 10 years, we are even more reluctant to provide any predictions.
Low interest rates are frustrating for investors who hold little debt, but a well-balanced portfolio is not dependent on interest rates to meet financial goals. Reallocating investments in reaction to Fed actions, inflation expectations and other risks is not a successful investment strategy. Just look at 2020 and what an investor sitting on the sidelines would have missed.
Instead, we’ll hold high quality bonds in our client portfolios that will continue to act as buffers against recession and pandemic-driven market drops, and use their price appreciation during these downturns as a resource for rebalancing. No matter what interest rates we face.