You may or may not have noticed that interest rates have been consistently in the news for quite a while. A client suggested I do a blog post on whether we should care about that topic.
The answer is if you are a borrower, or a saver/investor interest rates will impact you although it’s not an in your face effect. Rather it is a slow and subtle effect, something like how you get a cavity in your tooth.
Interest rates have been abnormally low since the financial crisis of 2008. In order to keep world economies afloat, central banks around the globe lowered interest rates so that people and companies would hopefully borrow money, which in turn would create economic activity. That tactic has worked well but if rates were to stay low they would have no tool in their tool box to use when the next recession/correction in the stock market comes. Hence rates have been rising.
Of course borrowers love low rates, especially borrowers who have variable rate mortgages and lines of credit. And used responsibly these 2 loans can help you achieve your financial goals more quickly. However, sometimes they can tempt people to take on too much debt which can be very dangerous when interest rates rise. And make no mistake, interest rates must rise or the next recession or correction will make the last one seem tame in comparison.
If you are a saver or investor or an insurance company or pension plan, low interest rates make you want to pull out your hair. Fixed income investments for example bonds, are negatively affected by low interest rates. If you are a retiree and want minimal risk in your retirement savings and your fixed income is eking out a barely positive rate of return that means your savings are not going to last as long. You might have to adjust your withdrawal rate, because you cannot control how long you will live.
Investors and companies who rely on fixed income investments must make more than inflation rate which has been difficult to do in the last decade.
Pension companies are mandated to have a conservative investment profile so their job is more difficult in a low rate environment. Insurance companies by law must keep a certain amount of reserves for claims and that reserve relies on mostly fixed income investments for their return.
Perhaps unfortunately because of the current low rate scenario the fixed income category has expanded and become a bit more creative. Fixed income investments usually rely on some form of borrowing which of course is affected by interest rates. Bonds are loans, Real Estate Investment Trusts(REIT), mortgage income corporations, for example all rely on favorable interest rates.
The cavity analogy is quite apt. It takes a long time of eating gummy bears, chocolate, milkshakes, pop, and cake to get a cavity. Borrowers have enjoyed a long run of cheap money. But like the vulnerable teeth eventually the party has to end. Let’s hope policy makers allow a graceful exit of the party of easy money.