Unless you have been sleeping under a rock for the past decade or two, you may have noticed that interest rates have fallen quite a bit. This is manifest in a few obvious places: the interest rates available to investors (e.g. bond yields) and the rates at which borrowers can borrow (e.g. mortgage rates).
Below are a few relevant charts.
Historical 10Y treasury yields (link). If you account for inflation, real yields are now negative!!!!
Historical 30Y mortgage rates (link).
Historical auto loan rates (link).
When interest rates fall, it’s good for the following groups:
- Existing owners of fixed income investments (e.g. bonds), thanks to the inverse relationship between interest rates and bond prices.
- Existing owners of stocks who benefit from inflated asset prices as investors “reach for yield.” Given the currently unappealing fixed-income investment alternatives, stocks become relatively more appealing in a low-interest rate environment.
- Existing owners of real estate who benefit from the asset bubble fueled by cheap money.
- Further, existing homeowners with a mortgage can refinance their mortgages to benefit from the lower interest rates. Yours truly did just that a month or two back, saving about $127/mo in interest.
- I’m less convinced that falling interest rates are good for new home buyers because of the offsetting effect of increased home prices.
Some pictures to illustrate:
Case Schiller home price index (link).
Growth of $1 invested in total stock & bond market indices since 2001. Dividend reinvestment is included but taxes are excluded. Source: Yahoo finance.
(I realize that interest rates are not set in a vacuum, of course, but are rather a result of complex interactions of the supply and the demand for credit.)
That said, it seems to me that the collapse of interest rates seems to have substantially exasperated wealth inequality. Owners of assets (stocks, bonds, real estate) have seen huge increases in wealth. This sounds great until you consider the other side of the equation — that those without assets are now living in a world with elevated asset prices and the associated baggage (lower expected returns & higher home prices).
So what’s the point of this doom and gloom post?
I’m not really sure, other than to point out a few key obvious points that I haven’t seen covered very much in the press:
- Those who have assets are doing relatively well. Those that don’t have assets are likely to be doing substantially less well. This is particularly true as we think about the implications of the current interest-rate-exasperated wealth divide compounded over the coming decades.
- Investors today face huge headwinds in a zero-interest-rate environment and should adjust their expectations for future returns accordingly.
- Riding a bike into a 20-25 mph headwind is something I do on an almost daily basis. It’s pretty miserable. Similarly, investing in a zero-interest rate environment is not going to be pleasant going forward, though the ride to zero has certainly been enjoyable for those of us with existing assets.
- When biking into a massive headwind, you 1.) downshift, 2.) pedal harder, and 3.) go slower. Analogous changes will be required for investors going forward. We’ll have to 1.) spend less, 2.) save more, and 3.) expect lower investment returns. I realize that recommending that one spend less and save more is easier said than done during a pandemic/recession.
- The 12.8% annualized return of the US Stock Market Index over the past 10Y (link) certainly isn’t sustainable going forward. Nor is the 3.5% annualized return of the US Bond Marked index over the past 10Y (link).
- For an investor with a multi-decade investing horizon (which should be a lot of us), I’d give a lot of thought about the appropriate role of bonds in your portfolio going forward. I don’t think the historical rules of thumb (e.g. “age in bonds”) necessarily apply in a zero-interest rate environment. Absent further drops in interest rates, those buying bonds today are locking in ~1% returns for the next decade or two.
- That said, going 100% stocks is certainly not a panacea. Due to elevated asset prices, stock holders have to get used to lower expected returns than they have historically been used to achieving. I don’t think it’s unreasonable to think that stocks returns could be in the neighborhood of 4-6%/year for the next decade+. Obviously, since stocks are risky, one has to be prepared to lose 50% of one’s portfolio tomorrow if one chooses the 100% equity path — not too dissimilar to what we saw in March of 2020.
- If a zero interest rate environment doesn’t bring investing costs to the forefront of investor’s minds, I don’t know what will. It’s one thing for advisors / mutual funds to skim 1-2%/year off the top of a 12.8% return for the past decade, but I think it’s an entirely different proposition to do so in an environment with 4-5% returns going forward. A 1% AUM fee + 1% actively managed mutual fund ER could potentially eat up 50% of the nominal return for investors in a given year, or 100% of an investor’s real return. Compounded over an many-decade investing lifetime, these fees are especially catastrophic in a low interest rate regime.
- I haven’t seen anything in the news indicating that AUM / mutual fund fees are the subject of increased scrutiny. I’m unsure why this is the case, but investor inattention never ceases to amaze me.
- It’ll be interesting to see if this is the death of the 1% ER actively managed bond fund industry. It’s hard to believe that such high expenses can be sustained in a zero-ish interest rate environment.
Am I being too melodramatic? How are you dealing with this zero interest rate world? Do you similarly find the thought of holding 1% yielding bonds for the next several decades repulsive?