Four factors keeping interest rates low
Investors are concerned that inflation will force central bankers to start raising interest rates. Even if they do rise from current rock-bottom levels, we think that long-term demographic and economic trends will keep them at relatively low levels for the foreseeable future.
Over the past 30 years, there has been a significant increase in both life expectancy and the average age of the population. This means that more people are expecting to spend longer in retirement, creating more incentive to save rather than consume. This a global phenomenon but it is more advanced in high-income countries.
40 has become the new 30
Median population age globally and in high-income countries
Source: UN, 2019
This has a double whammy effect. The swelling ranks of the middle aged will be forced to invest for their retirement, rather than spending on goods and services. This reduces growth, forcing central banks to keep short-term interest rates lower than might otherwise be the case. It also boosts demand for government bonds, depressing both short- and long-term yields. Pension funds looking after these huge pools of retirement savings often have little choice but to invest in government debt, however low the income on offer.
2. National debt
Government debt levels were on a long-term upwards path even before the pandemic. Covid-19 has caused them to lurch higher.
Government debt has jumped ahead of output
Government debt in advanced economies as a percentage of GDP
Source: IMF, 2021
The situation is manageable because low interest rates mean debt servicing costs are also low. However, that might not be the case if governments were forced to refinance in a higher rate environment.
This puts pressure on central banks to keep rates low. This could take the form of overt political pressure, undermining central banks’ independence. Even if central bankers have the stomach to stand up to governments, markets may force them into submission.
3. Global reserves
There is another big accumulation of savings putting downward pressure on global interest rates: global currency reserves. Following the Asian financial crisis of 1998, many emerging market countries significantly increased their foreign exchange reserves, primarily US dollars, as a defensive measure. These investors have been willing to pay a premium for safety and liquidity, putting further pressure on global interest rates.
Officials responsible for investing these huge pools of money cannot invest freely; they are required to hold safe assets – US Treasuries in particular. This has been a key driver of the increase in foreign ownership of US government bonds. On the eve of the pandemic, international investors owned around a third of US debt. This has fallen as a result of the Federal Reserve’s huge bond buying programmes, but overseas investors still account for over a quarter of the market.
Falling inflation – or disinflation – has been an important driver of lower interest rates over the past thirty years. When inflation is high or rising, savers and investors require a higher rate of return to compensate them for their loss of purchasing power. The reverse has been true for many years.
Before the pandemic, inflation remained low despite buoyant job markets in most developed economies. This unexpected outcome was the result of long-term structural trends, such as globalisation and technology. In very competitive sectors, companies have less power to raise prices. Meanwhile, new and disruptive business models allowed them to provide goods and services more cheaply than ever before.
Prices rising at a slower rate
Personal Consumption Expenditures Excluding Food and Energy, Annual Percent Change, Seasonally Adjusted
Source: Federal Reserve Bank of St. Louis
The long-term impact of the pandemic on inflation remains unclear. We are now seeing a pick-up in inflation as a result of higher commodity prices, bottlenecks in some parts of the economy and sharp price rises in the service sector (air travel, hotels, and hire cars are much more expensive than a year ago!). These could well be “transitory” impacts, as the Fed has suggested. The bigger question is whether the huge increase in the money supply we have seen over the past year will translate into price rises in the real economy.
There is good reason to think that technology could continue to limit price increases. We are only just starting to see the potential of robotics and artificial intelligence, for instance. Both could have a significant impact on employment, unleashing a new round of disinflationary pressure.
Managing wealth in an age of low interest rates
Markets are worried about the return of inflation and, in turn, higher interest rates. Unlike some, we believe low rates will remain a defining feature of markets in the years ahead. This has important implications when it comes to investing, and structuring, your wealth.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.