Why have interest rates fallen so much? Photo / iStock
Around most of the developed world interest rates have been trending downwards for as long as many people can remember.
A study by two Bank of England (BOE) economists late last year reckons that "long term real interest rates across the world have fallen by 4.5 per cent over the last 30 years". With declining inflation nominal rates are down by even more indeed I can remember buying 10 year NZI bonds at 18 per cent for my mother back in the mid 80's.
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Today long dated bonds from the likes of Auckland City Council yield around 3.65 per cent pa. Today's story looks at why interest rates globally have fallen and the implications for savers and borrowers.
So why have interest rates fallen so much?
To understand this it is useful to split interest rates into a real component and an inflation premium.
The biggest factor behind the fall in interest rates is the decline in inflation. Check out the graph below - in 1985 inflation was about 15 per cent in the 12 months ended December 2015 NZ inflation had fallen to less than 1 per cent. Interest rates have fallen with inflation.
So that is one big reason interest rates are down but the BOE study shows that real interest rates have fallen as well and the fall in real interest rates is particularly significant.
Look at the graph again - real short term interest rates in October 1988 - based on this historical data were wide at about 10 per cent but today real short rates have fallen to around about 2 per cent.
The BOE study reckons that although a slowdown in global growth has been generally held to be responsible for the fall in real interest rates shifts in saving and investment preferences appear to be a bigger factor in explaining the long term decline.
These latter factors are:
• Changes in demographics in the global population.
• Rising inequality.
• A trend towards higher savings by emerging market governments (principally China).
Briefly the BOE study says that as regards demographics spending is fairly stable over the life cycle and people of working age are those who tend to save the most.
Consequently the more people who are working the higher the level of savings and conversely the lower the proportion of the population who are dependents i.e. not of working age the higher the level of savings.
The study finds that although there has been a gradual rise in the age of the population a far more important factor has been the fall in the number of dependents in the last 30 years - from 50 per cent to 42 per cent.
This factor alone accounts for about 1 per cent of the fall in global real interest rates.
The BOE study makes some other useful points too: firstly the economists say that the low interest rate environment is going to stick around for a good deal longer and rates could go even lower. Secondly they reckon that loose monetary policy, the same one that the armchair economists/gold lovers warned was going to cause hyper inflation five years ago, is not the cause but the consequence of the fall in longer term rates.
So how could we respond to this changed environment?
There are three main ways that investors who are worried about low interest rates can potentially improve their returns. Unfortunately all three involve assuming higher levels of risk. Investors who want to stick with fixed interest investments can opt for riskier securities such as BBB or un-rated corporate bonds, finance company debentures etc etc.
The other option available is to invest in longer dated bonds because, all things being equal, longer dated bonds pay higher yields than shorter dated bonds. The third alternative is to invest in riskier asset classes like property and shares.
Lower interest rates obviously aren't good news for investors but it is not awfully clear that they are great news for borrowers either.
One problem with riskier asset classes however is that the fund management industry appropriates some of the higher returns for itself in fees. The fees involved in a bank deposit are close to zero and not disclosed to investors. The way the fund management industry works is that higher risk assets attract higher fees so investors need to be very focused on fees to make sure that when they invest in higher risk assets the bulk of the extra returns accrue to them rather than their financial advisor/fund manager.
The other thing that investors need to be aware of is that whenever interest rates are perceived to be low there is an inevitable response from the less reputable parts of the finance industry who quickly bring to market dodgy new products designed to appeal to retail investors unhappy with traditional bank deposits.
I'm thinking here of property syndicates which promise monthly payments but frequently fund those payments by simply returning the investors capital. These products typically have relatively high fees and relatively non-diversified, highly geared property portfolios i.e. they are high risk.
The other "innovation" that typically makes an appearance at times of low interest rates are "alternative investment funds" which comprise venture capital, hedge funds and other exotic strategies. Many of these funds over promise and under deliver not least because they are burdened with high fee structures.
No discussion of interest rates is complete without mentioning the behavioural trait known as anchoring.
Lower interest rates obviously aren't good news for investors but it is not awfully clear that they are great news for borrowers either.
Low interest rates imply low growth, low inflation and perhaps reduced job prospects. Back in the 1930s depression interest rates were low but house prices were falling along with the price of most other things and unemployment rocketed. The lower interest rates go more worried the market is that we are approaching deflationary times and deflation may be more difficult to address than inflation.
In addition higher levels of inflation mask falls in the real value of houses thereby protecting borrowers from falling into positions of negative equity. These risks raise the issue of whether borrowers should opt for floating or fixed interest rates. Fixing your mortgage interest rate is often held to be a risk mitigation strategy but that's not always correct. Fixing ones interest rate could be a risky strategy if interest rate swaps were to drop significantly as a result of a recession. Incidentally this is the reason why so many companies in NZ and overseas got burnt by interest rate swap whereby they fixed their interest rates to hedge against rising interest rates only to see rates fall rather than rise.
No discussion of interest rates is complete without mentioning the behavioural trait known as anchoring.
The anchoring effect is a well-known cognitive bias that influences one to rely too heavily on the initial information received.
In an interest rate context the reason so many financial advisers have given bad advice to their clients locally as regards constructing bond portfolios is because their view as to what was an appropriate interest rate was anchored in the past on high nominal rates.
For instance someone suffering from the anchoring bias who had been earning 6 per cent on 1 year deposits when confronted with 4 per cent is likely to feel that that interest rate is too low and decide to wait for rates to go up. Six months later when rates are down to 3 per cent they feel a bit silly not to mention less wealthy but they are unlikely to admit they made a mistake. Incidentally the BOE study observes that global long term real rates are now back to where they were prior to the two World Wars.
Some commentators have suggested that one way for retired individuals to cope with declining interest rates is to invest in a non KiwiSaver balanced fund. Next week we will look at what's on offer in NZ in terms of balanced funds and consider whether the risk/reward trade off after fees is worth it. Hint : in most cases it isn't.
"I was really wrapped up with what I was doing was who I was."