Low Interest Rates Are Not Good for You

Since the Global Financial Crisis central banks have been attempting to stimulate growth through extremely low and in many cases negative interest rates. Central banks are trying to encourage lending by banks and other financiers by penalising banks for holding deposits. At mid-2016 a quarter of the world’s economy are living with negative interest rates.

Former US Treasury Secretary Larry Summers earlier this year in Foreign Affairs magazine stated “Inflation for the entire industrial world is expected to be close to 1 percent for another decade and …real interest rates are expected to be around zero over that time frame.”

However investors and consumers have good reason to be concerned about low and negative interest rates. Annuity rates have collapsed and the ability of fund managers to generate long term investment returns has grown increasingly difficult as low rates fuel a bubble in overpriced assets.

Investment yields have been shown to be accurate predictors of future investment returns. Modelling conducted by Research Affiliates, a consultancy, showed that for over a century the starting yield on the US 10 year Treasury note has provided a highly accurate indication of the subsequent 10 year return on the note. Similar quasi-predictive ability exists for the investment grade bond market and global equities markets.

Larry Fink, CEO of Blackrock the world’s largest investment fund firm, highlighted in April that amid a persisting low yield environment investors need to constrain spending and save more to be able to meet the same future investment targets. Ratings agency Fitch estimates low rates are costing investors around US24billion annually. Current economic growth is being driven by consumer consumption, fuelled by low rate credit.

Like Fink, the International Monetary Fund has expressed concerns that should worry large asset owners like pension plans and insurers; “…low rates make it difficult for insurers to meet guaranteed returns and with substantial duration mismatches will eventually force losses on life insurance policyholders.”

Ray Dalio, owner of hedge fund Bridgewater Associates has echoed the IMF concerns, believing 85 percent of public pension funds are likely to fail within the next 30 years. At the same time, reforms designed to increase the stability of the financial system and the rise of passive investments like ETF’s are herding people into holding similar positions that will likely end badly when the next crash comes.

Jim Reid, strategist at Deutsche Bank, summarises;

“The combination of high money liquidity (from central bank policies) combines with low trading liquidity (from new regulations and bank capital constraints)…the former encourages investors to move in a similar direction until overheating occurs with the latter creating problems when they collectively lighten up.”

It is important to realise that low interest rates are distorting the functioning of investment markets creating asset bubbles. Investors need to realise that while low rates benefit consumption today it is at the expense of investment returns and ultimately, consumption tomorrow.