Life in a Low Interest Rate Environment
With Wednesday’s Fed rate cut and the European Central Bank’s massive stimulus package, low interest rates seem to be here to stay. For the millennial generation that entered adult life around the Great Recession, low interest rates appear to be the norm, but this is hardly the case. The Fed’s effective rate going back to 1955 (Chart 1) illustrates how unusual the times we live in are.
While it’s impossible to predict what will happen to interest rates next, an analysis of historical rates suggests a few clues. Up until 1998, the Fed often made minute changes to its effective rate in response to inflationary forces, and it was not uncommon for the Fed to raise rates just months after lowering them. Chart 2 lays out every Fed rate cut since 1971, with the size of the cut on the top of the chart, and the number of days before the bank started raising rates again on the bottom.
After 1998, the Fed stopped making small rate cuts; instead, as inflation became stable and the financial markets became increasingly efficient, the Fed adopted a more consistent and patient approach. Small rate changes became uncommon, and both the 2001 and 2007 rate cuts were steep and prolonged.
Since 1971 the Fed has, on average, lowered rates by 2.94 percentage points during a cut, although there is a large discrepancy between cuts made during a recession, and cuts of a more preventative nature, such as those made recently. While the mean duration between the last rate cut and the first rate increase is 395 days, the range spans from 12 days to a whopping 3,010 starting with the Great Recession.
So what comes next? The Fed’s dual mandate charges it with keeping inflation and unemployment at bay. But despite some worrying signs about softening job growth, these recent rate decreases appear to be driven more by political pressure coupled with trade-policy uncertainty, rather than changes to any actual macroeconomic conditions. And since the recent cuts have only sparked more criticism from President Trump and increased the uncertainty over the Fed’s intentions, it’s hard to imagine the central bank raising rates anytime soon. Couple these internal forces with unprecedented low and decreasing global interest rates, and it looks like the low interest rate environment is here to stay.
Low interest rates pose unique challenges for those trying to save for retirement or living off a fixed income, but also a few opportunities. Here are a list of personal financial steps worth remembering:
1. Don’t let your money sit in the bank. The average savings account earns just 2.1% annually, below the 2.4% annual inflation rate. This means that excess money sitting in your bank account is losing value. For almost any time horizon, there are better tools than saving accounts, from CDs, through treasuries, to corporate bonds. Shop around between banks for the best opportunity, and consider engaging an investment professional — for a modest advisor, the fee is likely to be more than covered by the additional return you’ll make relative to a savings account.
2. Refinance your mortgage, and any other fixed loans. While variable-rate loans will see an automatic reduction in interest payments, many mortgages and other loans are fixed and will not adjust automatically. With the average 30 year mortgage rate at 3.8%, near historic lows, and banks showing no signs of tightening consumer credit, this is a good time to lock in the low rates. Don’t have a mortgage? There are other ways to take advantage of the cheap credit, especially by using leveraged financed products.
3. For current income, use bond ladders. It’s impossible to predict what interest rates will do next. While it might be temping to sit on the sidelines and wait for interest rates to go up, that’s not an option for investors who need current income. This is the case for many defined benefit plans that are already struggling, and are likely to be further endangered by another prolonged period of low interest rates. Furthermore, interest rates might go down further before they go up. A good tool for managing this uncertainty is bond ladders, building a portfolio of bonds that mature over successive years. In this way, the longer durations are locked in at the higher interest rates, and the shorter duration bonds with low interest rates can be reinvested for longer durations as they mature, hopefully at higher rates.
4. For long term growth in your portfolio, increase equity exposure, or leverage. There are no free lunches in investing. The low interest rate environment does not appear to be going anywhere anytime soon, and that means that the fixed income allocation in your portfolio is not going to contribute as much to your wealth as it has historically. This is especially bad news, given the already poor state of savings by younger generations. (A growing percentage of millennials have absolutely nothing saved.) There are no silver bullets here, only old truths: create a financial plan, take advantage of tax-deferred vehicles like 401K and IRAs, and take on more risk when you can afford to do so, either in the form of increased equity exposure or by taking on leverage. The latter can be done by direct borrowing (margin), but for most investors, leveraged financial products, like some kinds of ETFs, are more cost efficient.
Low interest rates look like they are here to stay, and there are few silver linings. Overall, it means investors will have to work harder to achieve their investment goals, so having a financial plan and shopping around for the best rates are critical. If possible, be a borrower rather than a lender, although leverage of all sorts come with risks. And finally remember, this too shall pass.
-AD
