Will Interest Rates Ever Rise Again?
One of the byproducts of the Coronavirus recession has been a return to record low interest rates around the world, with many countries back at near zero or even negative interest rates. I want to spend a few minutes to highlight some challenges that we may see in the next few years that we have not seen in decades.
One particular statistic has caused me to think about this topic over the past few weeks. It was an item in a daily news briefing from Bloomberg News on September 1st which stated: “The negative rates in Europe are crushing pension payouts and directly hitting consumer spending. A pensioner who retired in 2018 has lost on average the equivalent of 350 Euro a month ($410 U.S.) in purchasing power over the duration of their retirement, according to a study by the consultancy group IFA”. U.S. interest rates are increasingly moving to negative levels when adjusted for inflation, a similar challenge may face retirees in the U.S. in the next few years. I will discuss the challenge, some seemingly contradictory policy moves from the Federal Reserve Board, and things that we can do as investors to navigate through such an environment, if it does develop.
Will we be following Europe?
Europe has moved to a policy of negative interest rates over the past few years in an effort to further stimulate their economy by lowering borrowing costs. The yields on many government bonds are negative on both a before and after inflation basis as shown on the table below:
|Current Yield||Inflation -Adjusted Yield|
While many investors will correctly determine that it is not worth paying the government to hold their money, there are groups such as banks, insurance companies, and pension funds that are required to keep significant percentages of their investment portfolios in these bonds. These negative rates are what is driving lower returns and payouts on CDs and annuities to pension benefits, and ultimately to retirees. In the U.S. we are not as low as Europe on a nominal basis, but they are quite similar once adjusted for inflation. Here is what our interest rates look like:
|Current Yield||Inflation-Adjusted Yield|
The Federal Reserve Bank has indicated that they do not believe in pursuing a negative interest rate policy at this time. However, a sustained low interest rate environment that keeps interest rates below the rate of inflation could have a similar impact on U.S. retirees in the coming years unless interest rates move back to more normal inflation-adjusted levels in the future. Currently the prospect of the Federal Reserve raising rates seems a ways off as indicated by the Federal Reserve Chairman’s’ recent comment stating. “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates. What we’re thinking about is providing support for the economy. We think this is going to take some time” (source New York Times 9/16/2020)
What would likely drive rates higher in the coming years?
The Federal Reserve has indicated that they plan to keep interest rates very low, they have also recently announced that they want to see inflation get back to their 2% annualized target, and are willing to let inflation stay above 2% for a period of time in order to make up for the time in which it has been below 2% in the past. This is a very interesting development. The high inflation of the 1970’s came out of a reluctance to hike interest rates when inflation began to run higher than expected in the late 1960’s, and they were not able to fix the problem until the early 1980’s when a new Federal Reserve Chairman undertook an aggressive program to break the back of inflation by increasing interest rates sharply.
The country had to endure two recessions in short succession, but inflation did come under control, and from that time until now, the Federal Reserve’s interest rate policy has been to proactively hike rates to stem increasing inflation and to avoid a repeat of the 1970’s levels of high inflation. As a result, in the near term, we are likely to see all interest rates remain low. If we start to see inflation begin to build, the interest rates that the Federal Reserve controls will remain low, while longer-term interest rates, which are driven by supply and demand, are likely to rise, and eventually the Federal Reserve will hike short-term interest rates until inflation stabilizes.
What does this mean for us as investors? Here are the primary takeaways:
- The Federal Reserve is once again making it financially painful to hold cash. It can remain safe in insured short-term accounts, but you will not be able to keep up with inflation, and you are likely to see the purchasing power eroding at a faster pace than usual.
- Targeted payouts from pensions, insurance policies, and annuities to future retirees are going to be harder to achieve as below-average interest rates from bonds are going to make it increasingly more difficult for these large institutions to reach their targeted returns.
- High-Quality bonds with longer maturities and fixed interest rates are an okay place to be right now, but if inflation begins to pick up, they could become the worst performing areas of the bond market.
- For investors looking at income sources during retirement, Income from Social Security is increasingly important as a stable income source where the income stream is adjusted upward for inflation. It will take an increasingly large amount of money to replicate the government backed income stream that you receive from Social Security. If you have not yet started taking social security, you may want to look closely at the potential benefits of delaying your benefit start date in return for a higher monthly income.
- The large amounts of government stimulus from around the world may push inflation higher, and if it does, the Federal Reserve will let it move to above-average levels before taking action. This policy of letting inflation run at above-average levels could push yields on long-term bonds higher, and push the prices of those bonds lower. Investors will need to be careful with these types of bonds.
Adapting to this new environment
In this changing environment we will need to be more cautious than we have had to be in decades about inflation getting out of control. While this may not be a high probability event, due to the large amount of debt that is in the economic system, it is a higher risk than it has been in past years. As a result, if we do see inflation beginning to show up, we will have a preference for floating rate bonds over fixed rate bonds to minimize loss potential in our income portfolios.
Another adjustment that we will all need to make in this environment is to decide if we are willing to take on more risk in an effort to maintain the type of return levels that we have typically seen from bond investments, or whether we prefer to stay at current risk levels and accept the lower returns from bonds that we are likely to see in the coming years.
The final adjustment that I will mention is the important benefit of having multiple asset classes in your investment portfolio. The asset classes that do well in one type of economic environment may not do well in another type of environment. Therefore, a willingness to be flexible in your investment approach is an important key to long-term investment success, because there is no one perfect investment.
Our goal is to evaluate the changing investment climate, and to do our best to adapt the investments and investment strategies that we have available to help you reach your financial goals. We believe that there are some upcoming challenges, but we also believe that we will also find some very good opportunities as well.
Michael Ball CFP®
Weatherstone Capital Management, a Transform Wealth, LLC (Transform Wealth) company, is a Registered Investment Adviser with the U.S. Securities and Exchange Commission (SEC). Transform Wealth is a wholly-owned subsidiary of Focus Operating, LLC. which is a wholly-owned subsidiary of Focus LLC. The content is for informational purposes only and does not represent an investment recommendation by Weatherstone Capital Management or Transform Wealth. More information about Weatherstone Capital Management and Transform Wealth, including our investment portfolios, strategies, fees, and objectives can be found in our respective ADV Part 2A Brochures, available upon request.
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