ECONOMISTS said it could not happen, yet rich-world central banks are starting to impose negative interest rates on depositors. Imagine depositing money with a bank with the full knowledge that you will receive less back when you withdraw.
Japan, The ECB, Germany, Denmark and Switzerland now have NEGATIVE interest rates out as far as ten years. US and Canadian rates are pathetically low but still positive, ranging between 0.25% and 2.0%. That could change should the current trend continue.
At the end of April, 2016, $8 trillion in government bonds worldwide offered yields below zero.
Negative interest rates are an act of desperation, a signal that all other traditional government policy options have proved ineffective and new actions need to be explored. ECB President Mario Draghi said in January that there are ‘no limits’ on what he will do to meet his mandate.
When an economy is struggling it is standard practise for a central bank to cut interest rates, making saving less attractive and borrowing more attractive, thereby boosting the amount of spending and kick-starting an economic recovery.
Central Banks have ‘thrown the kitchen sink’ at investors in an effort to reignite inflation: massive fiscal spending; lower interest rates; quantitative easing- buying bonds. Nothing has worked to this point to spur inflation. What else can Central Banks and or Governments do? A ‘helicopter drop.’ Imagine waking up one morning and you find thousands of $100 bills in your backyard, along with all of your neighbours. A former US Federal Reserve Bank Chairman actually alluded to this possibility several years ago in a speech. It won’t happen.
The recent plunge in global interest rates has occurred in the sixth year of a recovery during which most of the developed world has run record deficits and created massive amounts of new currency.
Theory states that if nominal interest rates stay negative investors will withdraw their cash and store it themselves, emptying banks and crashing the financial system. We are not there. Hundreds of millions of investors around the world are willing to accept less for money in the future, for the security of storing their cash in a bank rather than under their mattress. An aging population equals low interest rates. Baby boomers are retiring. They invest less and spend more. Less new savings is coming in to the system. The central banks and governments are trying to compensate for this long and painfully slow evolution of the amount of money available to spend.
Beyond a certain point, debt is deflationary. Loans have to be paid back with funds that otherwise might go toward new investments and consumption. Today’s unprecedented levels of debt thus create an economic headwind that requires more forceful monetary policy eg. negative interest rates, to induce even more borrowing.
It is a fact that ‘money velocity’, (the rate at which new currency is spent), continues to fall. Central bank efforts are less effective….the law of diminishing returns. Pardon the pun.
The Effect on You:
Most of us are working hard, trying to build wealth, save money and eventually have the health and financial freedom to do whatever we want.
One obvious side effect of ultra-low interest rates is to force you, as an investor, retiree, pension fund and others who need positive cash flow, to move further out on the risk spectrum. Rather than accepting lower GIC rates you will likely gravitate to other investment vehicles: High Yield Bonds, Preferred Shares, Emerging Market Debt and dividend paying Equities.
I see this in every day conversations with my clients: “Tim, I am not going to buy a five year GIC at 2.0%. What else is there?”
Two years in to the experiment, it is too early to tell if negative rates will work but central banks say that so far the costs have been manageable. However, if more and more central banks use negative rates as a stimulus tool it may lead to currency wars of competitive devaluations.
How should you manage your hard earned savings in this environment?
- Expect lower future returns on your investments.
- Be very careful when considering extending your savings out in to higher risk investments.
- Advise your younger family members and friends to not take on large home equity loans or mortgages just because interest rates are low now.
- Keep a keen eye on the percentage of capital you are spending on an annual basis. (We can help you with that).
- Manage your investments in currencies that you plan to spend. Exposure to foreign currency in retirement can affect your home currency returns significantly. If you are younger you can afford to wait out negative currency returns.
Please know that we, at Cornwall Wealth Management, have the knowledge to help guide you through these ever changing and challenging times, to generate and preserve your wealth.
Sources: Bloomberg, The New York Times, The Wall Street Journal, The Economist.
Written by: Tim Wilson, CFP, CIM, Investment Advisor June 15, 2016
Note: The opinions expressed here are Tim Wilson's. Cornwall Wealth Management Group/Manulife Securities Incorporated are not responsible for the accuracy of any of the information supplied here.