How Low Can They Go?

"How low can you go? 
I could go low, (go low) lower than you know,
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know" - Lyrics from the song How Low Can You Go by Ludacris

Low interest rates are a source of frustration for retirees and joy for investors.  On one side of the coin you have those trying to live off interest payments and on the other you have the people borrowing money.  The first group (mainly retirees) have seen their livelihood evaporate while home buyers, businesses and others borrowing money have seen the cost of borrowing fall to record lows.  In the United States you can buy a house with a mortgage rate of less than 3.5% which makes home ownership very affordable, but try living on interest income of less than 3%!  Take as an example of a person with $1 million in retirement savings who was expecting to earn 6% or $60,000 a year.  This income has now fallen to less than a third and means that this person will have to dig into their principle eroding future income all the while losing to inflation.  This person's retirement plans are being destroyed. 

Now while we could go into options available to them the question that most people are asking is how much longer can interest rates remain low and I will argue that not only with they remain low for years to come, but there is a high probability that they could go a lot lower.  The reasons for my outlook are numerous but I will expound on a few main points in this blog starting with the Federal Reserve's desire to keep them low. 

While the Federal Reserve does not have complete control over market forces they can influence them significantly and through continued stimulus and by holding bank rates down they have effectively managed to keep the lid on any increases.  Furthermore with their share of market debt rising significantly and congresses lack of ability to balance the budget they have a huge incentive to keep borrowing costs down. To take the example above and place it into the context of the Federal Reserve and Washington (and I will use a round number of $20 trillion as it looks like we will be there sooner rather than later) if you pay interest on $20 trillion at around 3% versus 6% you are saving $600 billion a year.  Now that might not seem like a lot in terms of the nominal value of the debt but if you put it into the context of balancing the budget it makes a huge difference.  Right now we run a $600 billion deficit, add the increased payment of $600 billion and suddenly the budget deficit doubles!  Certainly a huge incentive to keep the lid on interest rates as long as possible.

The next area to look to is the market.  The market is made up of banks and institutions and foreign governments.  Looking abroad at Europe and Japan and the picture becomes very interesting.  I looked at the 10 year rates around the world and it is truly eye opening.  The rate in the United States is approximately 2.60%.  In comparison, Japan is 0.60%, Switzerland is 0.80%, Germany 1.45%, Netherlands 1.77% and France at 1.92% all of which are substantially lower than the United States.  In fact Italy at 3.04% and Spain at 2.97% are pretty much in line with the United States and Mexico at 3.67% and Portugal at 3.60% are not a lot higher.  If I were surveying the investment scene around the world to place a large amount of money I would be hard pressed not to invest in the United States as the security offered for one of the best rates in the globe makes it a compelling alternative.  More investment means prices of bonds go up and this then keeps the lid on rates and can force them lower.

The final piece to this puzzle is inflation.  Without inflation there is no requirement to raise rates so it is very interesting to note that one of the reasons the European rates are so low is that due to their austerity they are now staring at deflation.  If they enter a deflationary spiral similar to the one that has plagued Japan for decades we could easily see a world where rates remain muted for a very long time regardless of what the Federal Reserve does. 

This will have a huge impact on your retirement and investment outlook so make sure that you factor this into your portfolio as the odds are high that interest rates fall further from here even though ( and maybe because of the fact that) consensus tells you otherwise.  This is why I repeated the lines in the quote four times (like they do in the song) just to remind you that lower is possible.