How low can interest rates go?
In June, the yield on the 10-year US Treasury bond reached a new low of 1.47%, breaking the previous low of 1.48% in 1947. Then on July 16, the yield went even lower, dropping to 1.44% during the day before closing at 1.46%. And when financial commentators speak of record lows for the US economy, the time frame stretches all the way back to 1790, the beginning of the nation! (see chart below.)
The 10-year US government security yield, often cited as a key indicator of the national economy, also reflects borrower costs and lender returns in a variety of other financial instruments. That same day, mortgage lender Freddie Mac reported the average mortgage rate also hit a record low, at 3.56%. The U.S. Prime Rate, the interest rate at which banks lend money to their most creditworthy business customers, stood at 3.25%.
Here are some annual interest rates for different savings vehicles as of July 16, 2012:
6-mo. Certificate of Deposit… 0.46%
1-year CD …………………… 0.69%
5-year CD ……………….. 1.42%
Money Market Account… 0.49%
So…this means a 1-year CD of $10,000 will generate $69 in interest. Seeing these numbers, is easy to see why some financial commentators have called current savings account offerings the “land of no return.”
Interest rates and consumer borrowing
In “normal” circumstances, lower borrowing costs could be expected to increase lending; businesses and consumers could use the “easy money” to expand operations, hire more people, buy more stuff. But with the fallout from the recent financial downturn still fresh in their minds, combined with anxiety over anemic retirement funds, many Americans have been hesitant to take on more debt, even at lower rates. Restructure existing debt, yes – but not borrow more.
A Wall Street Journal article earlier this month noted that personal savings rate in June hit its highest level in a year, rising to 4.4% of disposable income from a recent low of 3.2% last November. (To put the savings rate into perspective, it averaged 2.7% in the five years before the recession.) A collective change in attitude about debt has blunted the management efforts of government economists, who assumed that low interest rates would stimulate the economy through new debt.
This save-not-spend behavior reflects the dilemma of one of America’s biggest cohort of savers: retirees. Retirees who rely on their safe, conservative, yield-bearing, financial instruments to provide a secure income stream are severely impacted by low interest rates. Lower rates may mean choosing between living on a reduced income, or dipping into principal to maintain lifestyle. Even though lower rates were intended to stimulate growth, a segment of the population with the greatest amount of cash doesn’t feel it’s safe to spend it.
The Upside of Low Interest Rates
But while the returns from many guaranteed accumulation options are historically low, there are also some advantages of this low interest rate environment.
Low interest rates can be considered a reflection of the relative strength and stability of the American economy. As Marc Gongloff wrote in a May 30, 2012, HuffPost article, “The U.S. and Germany are having an easy time borrowing right now mainly because they are seen as safe havens in a world where every other investment suddenly looks horrible.”
Gongloff goes on to mention the financial crises plaguing several European countries, as well as the economic slowdown in China, and concludes that, right now, higher yields and borrowing costs coincide with much higher risk and uncertainty. Even with low yields, global investors prefer American debt because of its perceived safety. In short, the assurance of return of investment here beats the prospects of return on investment almost anywhere else.
Whether low interest rates benefit you or frustrate you depends largely on if you’re borrowing or investing. But there are opportunities presented by low interest rates that are worth taking advantage of:
Business expansion opportunities. A challenge for all prospective borrowers is meeting the tougher lending requirements that have come in the wake of the recent financial crisis. But, if they qualify, today’s lower interest rates have made it possible for many businesses and individuals to reduce the costs of their current obligations.
For businesses, lower borrowing costs can improve a company’s financial health and offer a chance to increase long-term profitability. Whether it’s time for newer and better equipment or time to expand inventory, low interest rates can help.
Refinancing and restructuring debt. The combination of tighter lending standards and low rates has helped businesses and households with solid financial footing become even stronger. Qualified individuals may find significant savings by refinancing their mortgages, switching credit cards, and restructuring other loan arrangements. Oftentimes cash can be freed up to spend today while overall interest paid is reduced.
Changing of investment priorities. The recent instability of stock and real estate markets combined with historically disappointing rates of “safe” investments such as certificates of deposit has led some investors to explore new strategies. No longer content to earn 1% at the bank or gamble in the market, investors are seeking strategies that will beat the banks with very limited risk. Investors are realizing that speculation is a poor financial strategy, and that’s a good thing!
Be the middleman. Some people have become both borrower and lender. Combining their ability to borrow at record low rates with investments with investments offering guaranteed returns such as tax lien certificates or bridge loans, some investors are making reliable returns that put the banks to shame – with none of their own principle.
Store cash in whole life insurance. With a myriad of options for saving, deferring taxes, future hassle-free borrowing, and receiving reliable dividends, this tried-and-true financial instrument of our grandparents has made a comeback. As James Hunt, actuary interviewed for the Wall Street Journal confessed, it’s hard to make a “term life and bond fund work better than a good whole-life policy.”
Will interest rates eventually go up?
The simple answer: They almost have to. According to data published by fedprimerate.com, the average U.S. Prime Rate since 1947 is 9.842%, and the most frequent Prime Rate value has been 7.5%. Compared to today’s Prime Rate of 3.25%, those numbers may be hard to imagine, for both lenders and borrowers. Then consider that in January 1981, the Prime Rate hit 21.5% – and people were still borrowing!
Based on history and statistical theory, interest rates should be expected to increase. The next question is: how soon?
That’s hard to say. In the 1990s, the financial managers of the Japanese economy lowered interest rates to almost zero following a recession – and rates have remained low for more than a decade and Japan’s economy has stagnated. Then again, some other factor – war, new technology, a change in tax policy – could result in a dramatic change in a very short period of time.
If you haven’t adjusted your financial strategies to reflect the low interest environment, now is the time!
Are you looking for ways to leave the “Land of No Return” without taking excessive risk?
It’s an ideal time to review your options, recalibrate your objectives, and measure the efficiency of your current strategies. Contact your prosperity economics™ advisor, or give us a call at (877) 889-3981, ext 120.