The precariousness of low interest rates: Part 1

This article appears in the February 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition or read the articles online.

Low interest rates make life difficult for savers, retirees, pension plans and central banks. But because markets fluctuate, we expect rates to rebound. What happens if they don’t?

Low rates impact monetary policy and investor expectations. Some countries have even come to know the curious reality of negative interest rates, which we’ll explore next time in Part 2.

Ten-year government bond yields in Canada and the U.S. (see Chart 1) have fallen from around 10% to 2% over 30 years. Their rebound anytime soon is far from certain.

Central banks used low interest rates and quantitative easing to flood capital markets with liquidity during the 2008-2009 global financial crisis. Most financial institutions and economies stayed afloat, but if a crisis occurred today, there’s significantly less room to manoeuvre.

Low interest rates mean pension plans must increase contributions, reduce benefits and/or take more investment risk to meet retirement payouts. Investors must similarly adjust to meet their goals. Deferring consumption is never a happy choice, particularly if rates stay low.

Future rates are a function of:

• expected inflation;
• expected short-term interest rates; and
• a term premium that compensates investors for the risk of holding long-term assets exposed to interest-rate and inflation volatility.

None of these factors indicates that higher rates are a sure thing. Organization for Economic Co-operation and Development inflation expectations for 2021 are 2.0% for Canada and 2.2% for all OECD countries.

Expected short-term rates

Interest rates will stay low if the demand for low-risk assets exceeds supply. A number of factors are contributing to higher demand. Since the financial crisis, investors have a growing appetite for “safe” U.S. Treasurys, and banks have higher reserve requirements. Aging populations emphasize saving over spending.

Meanwhile, supply has been affected by the Federal Reserve’s three significant long-duration Treasury and mortgage-backed securities purchase programmes between 2008 and 2014, and asset purchases by U.K., European and Japanese central banks.

Investment strategies start with a neutral or “risk-free” rate of return (r*), the hypothetical return achievable without chance of loss for a given time period. Normally represented by short-term government bond yields, estimates for r* are shown in Chart 2 for the U.S. and for other countries (Canada, the Euro zone and the U.K.). The risk-free rate was over 2.5% before 2008 but has since stabilized below 1%.

Term premium

The term premium has fallen over the past 20 years in the U.S. from 2% in 1988 to effectively zero since 2011, according to the Federal Reserve Bank of New York. “Whack-a-mole” monetary intervention and the expectation of Fed vigilance against inflation have helped to drive and keep the term premium low.

Oil-price-induced double-digit inflation in the 1970s, complicated by plummeting stock prices and uncertainty from the end of fixed exchange rates, proved a conundrum. The psychology of spiralling inflation could not be broken until Federal Reserve Board chairman Paul Volcker boldly raised interest rates well in excess of inflation, exceeding 20% at one point in 1981, to choke off demand. Whenever inflation’s head popped up, the Fed “whacked” it with aggressive rate hikes. Note the large gap between the effective funds rate and CPI after 1980 — until 2008 (Chart 3).

“Whack-a-mole” policy reduced U.S. core inflation and inflation volatility dramatically. Low inflation volatility is important in tempering expectations, suggesting lower interest rates for the near and intermediate future.

Source: Federal Reserve Board staff calculations; Haver Analytics; Feenstra, Inklar, Timmer, American Economic Review.

If r* is 1%, inflation is 2% (Canada), and the risk premium is effectively zero, expecting returns significantly above 3% requires explanation. Large pension plans have been reducing their return assumptions, or discount rates, as rates have declined. The Ontario Municipal Employees Retirement System is at 4% (down from 6% two years ago) and the Ontario Teachers’ Pension Plan is at 4.8%.

Recent double-digit equity returns obscure the fact that return assumptions of 4% to 5% are prudent targets for the coming decade. Using lower-cost vehicles is one of the most effective strategies advisors can employ to help clients address a low-return environment.

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.