One of the strange things about what’s happening in the world today is that interest rates for loans are at all time lows in North America, Europe, and parts of Asia. In some places the reference rates set by central banks are even in negative territory. In other words, the borrower is actually paid to borrow the money. If that seems unbelievable to you, you’re not alone as it also seems unbelievable to me. There’s a lot to unpack in figuring out how interest rates have gotten to these extremely low levels, and no one really knows what effect it will have on the long term. But in the interest of helping you try and understand it, and perhaps giving you my best guess as to where it will lead, I thought I would take a stab at unpacking this very complicated issue.
I think the best place to start is at the basics. In a normal free market, borrowers and lenders would be free to set whatever interest rate they like (or for borrowers, what they are willing to accept). For many borrowers, this is exactly how they view their loans. They walk into a bank to borrow money for a mortgage or for a business, the bank sets an interest rate that they would be willing to lend at, and the borrower either accepts the loan or goes to another lender to try and find a better deal. This process is relatively straightforward and simple.
Now in order to understand interest rates it’s important to understand it from the lender’s perspective and not just from the borrower’s perspective. The majority of loans nowadays are loaned by banks. Where do the banks get the money to lend? Well they have a variety of sources of funding, but primarily they raise money by taking deposits from their customers, which they in turn use to lend out. So you put money into your bank account, the bank takes your money and lends it to someone else, and the bank charges them an interest rate until that borrower pays the loan back. Still relatively simple.
Now we get into the complicated stuff. From the above example we can show that banks are actually lending money that ultimately they got from their depositors. This means that they’ve lent money which can actually be withdrawn at any time. Because of this, banks need to have cash available to pay out depositors who want to withdraw their funds. If you or I walks into a bank branch, we want to know that the ATM will dispense the cash that we have in our chequing accounts. But as a practical matter, depositors are unlikely to withdraw all of their money at once en masse, so Banks only need to keep a minimum reserve of cash available for withdrawals. In many countries, there is a minimum reserve which is set by law. In the United States the reserve ratio is 10%. That means that for every $10 of deposits a bank has, they only need to keep $1 of cash available as a reserve. That means they are lending out the other $9 which as we’ve already shown ultimately belongs to their depositors. These reserve ratios can be adjusted periodically by bank regulators but generally speaking banks are only required to keep in reserve a small fraction of their deposits. This is why banking can be a great business!
The downside to only keeping a fraction of the deposits on reserve at any given time is there is the potential for a “run on the bank”. When a run happens, the ensuing panic can hurt or even destroy healthy and solvent banks. That’s why financial crises like 2008 can be so scary for financial markets. A run is when depositors fear that the bank will fail, and they all rush to withdraw their deposits at the same time. This can happen because the bank is actually weak, or it can even happen when it’s depositors THINK it is weak. As we just learned, the Bank can’t honor all of these withdrawal requests because they simply don’t have the cash available because they only keep a small reserve. The bank may be able to call back loans but this can be extremely difficult to do quickly even under normal circumstances, let alone during a financial panic. Bank runs and the ensuing bank failures were a leading cause of the Great Depression in the 1930s. The stock market crash gets a lot of the credit for the depression but it was the ensuing bank failures and their effect on the economy which really caused the depression to be as bad as it was. In order to try and protect against these bank runs, the Governments in many countries have created what’s called a “Lender of Last Resort”. In theory the lender of last resort is there to step in when a run on a bank is occurring.
As the lender of last resort, the Federal Reserve allows lenders to borrow funds in the short term if they find themselves below their reserve requirement. This is similar to other Central Banks in other countries. Banks borrow these funds at the overnight interest rate. As a result the basis of the banks funding is set by that overnight interest rate. That overnight interest rate is set by the Federal Reserve based on the economic conditions at any given time. It is not a rate set by the market. It is dictated by the Federal Reserve. Because it’s such an important rate though, it has knock on effects on all of the other loans that banks do. For one thing, a bank is never going to lend for less than the overnight lending rate if they can help it. The whole premise of banking is that you’re going to lend money for a higher interest rate then what it costs you. If a bank were to lend money at less than the overnight rate, they almost certainly would lose money on that loan. Many loans are even set as a floating rate with the overnight lending rate used as a reference rate. That way the bank lender can be assured that even if interest rates rise, their loan will always be above the overnight rate.
So the overnight rate tends to have a pretty dramatic effect on interest rates on all loans in the wider economy. And that finally leads us back to where we started… the lowest interest rates we’ve ever seen.
Since 2008, central banks around the world have kept their overnight lending rates at or near 0%. As I already mentioned, some of the banks have even set their rates below 0 to try and encourage banks to lend more and stimulate the economy. Because central banks have artificially kept overnight rates lower then the market would probably allow, we’ve seen that filter into all kinds of loans for businesses and for mortgages. As a result your mortgage is probably a lower interest rate then you’ve probably ever had, and our clients who are business owners are likely paying less than they normally would as well. Central Banks have kept rates so low because of the extreme financial collapse in 2008 and the ensuing recession. Sluggish growth in developed economies has encouraged them to keep rates low. They’ve been able to do this so far because inflation is low.
It’s almost impossible to prove the reasons for why inflation is so low. It could have to do with the 2008 financial crisis and the aftermath of that. It could also have to do with increasing globalization and trade which has kept wages lower in many developed countries. It could also be because baby boomers (who account for a majority of the wealth in the world) have moved past the highest spending years of their lives and are now close to or in retirement. It could also be because technology has allowed us to produce goods and services much more efficiently than ever before. I tend to think that all of these reasons have been a factor and will continue to be a factor going forward. However if I’m right, it stands to reason that lower interest rates aren’t going to make much of a difference as many of the factors are unrelated to interest rates.
So where is all this going? Well that is extremely hard to tell, and frankly I don’t put much stock into forecasts on interest rates, nor do I think you should either. What I would say though is that I do think rates will eventually return to a more reasonable… higher level. That could happen in the next few years or it might take 20 years. I really don’t know.
A prudent investor will do a few things to shelter themselves as much as possible from higher rates, whenever they come. Even though rates are low now, that doesn’t mean you should borrow as much as possible. There are many Canadians who would struggle to service their current debt obligations even with only a modest increase in interest rates. This is a big problem and is the type of thing which could cause a recession if rates rose quickly and a number of borrowers default. Another thing investors can do is to invest cautiously. We really are in uncharted territory as far as record low rates. No one knows what the side effects of that will be. As a result, we need to be extra careful not to invest in risky investments or companies that are highly leveraged. These will not go well if interest rates spike. Quite simply we need to follow Warren Buffett’s rules for investing:
Rule #1 – Never Lose Money
Rule #2 – Never forget Rule #1
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.