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Low Interest Rates – Good today, but bad tomorrow?

Low Interest Rates – Good today, but bad tomorrow?


Blog by Jean M Rosenbaum, CFA, Hotaling Investment Management, LLC

 

Borrowers typically find low interest rates very attractive because it reduces the amount of money they have to repay to their lender. Think about the impact of lower interest rates on your mortgage or your auto loan!

Savers on the other hand, find them less attractive as lower interest rates means lower earnings on their savings such as bank deposits, CDs or bonds. Have you seen the rates on bank “interest” checking and savings accounts?!

While a brief period can be positive for consumption, an extended period of low interest rates can cause some long term problems. The longer rates remain low, the more difficult it will be to generate income and savings needed for future consumption.  The lower rates mean lower earnings for pension funds which rely on investment gains to meet their obligations.  Insurance companies may also find it increasingly difficult to meet their obligations as the return on their investment portfolios continues to fall below previous assumptions.  When the obligations for these firms were first established years ago, the assumption was the investment portfolio would grow and in some cases, the growth is critical to their ability to meet the future obligations.  This situation could result in individuals receiving less money (or even no money) from sources they had previously believed were secure. 

Taking this a step further, many European debt instruments are yielding negative rates. Negative interest rates means that investors pay to hold debt obligations as opposed to a positive rate environment where investors get paid to take risk and hold the debt of another entity.  In the case of an investment portfolio that holds negatively yielding instruments, the investment portfolio will shrink!  These companies cannot abandon the bond markets as they are regulated by their respective governments.  The basic operating assumption of these organizations is that they can take in money and then generate a positive investment return and meet or exceed their obligations.  This assumption has now been turned upside down as investment returns are meager at best.

The low interest rates helped consumption at a time when the sales of consumer durable items (houses, cars, etc.) were at very low levels. These sectors have recovered, but the ongoing environment of ever lower rates could cause more serious long term damage.  Workers that have entered retirement may need to find a new source of income which could be very difficult.  New workers will need to save even more money than expected to counteract the inability to generate a positive return or accept greater risk and/or volatility in their investment portfolios.  With one part of the population saving more and another receiving less income, the outlook for consumption growth looks difficult.  The economy could remain in a slow growth or even deflationary environment due to the “medicine” that has been used to try to counteract the problem of low economic growth.