- 1 Jul 2011
- The Gazette
- JOHN ARCHER on investing
“Interest rates across the world were lowered even further to keep the economies afloat.”
For many, it is a mystery as to why interest rates are so low and what will possibly cause them to rise one day. This question has challenged investors for decades.
A country’s central bank generally sets interest rate policy.
In Canada, it is set by the Bank of Canada Governing Council which, at the present time, is chaired by governor Mark Carney, while in the U.S. it is set by the Federal Open Market Committee, which is chaired by Ben Bernanke.
The Bank of Canada’s role is to keep inflation within their desired range. One of their main tools for controlling inflation is to increase or decrease the cost of money into the economy through the lowering or raising of interest rates.
Since the early 1980s, the trend has been the lowering of interest rates to keep the economy from tipping into a recession.
Low rates in turn helped contribute to a so-called “housing bubble” in the U.S, which imploded into a full-blown global financial crisis in 2008.
To avert a complete meltdown of the entire financial system and to help minimize the impact of the resulting recession, interest rates throughout the world were lowered even further to keep the economies afloat.
Some may recall the interest rates of the early 1980s when an investment in a 10year Government of Canada bond would yield as much as 16 per cent.
However, what they fail to remember is that inflation (the Consumer Price Index, or CPI, which is a measure of the cost of a basket of typical consumer goods) was running near 12 per cent.
This meant that the real rate of return (the difference between the interest rate and the rate of inflation) produced a four-per-cent return.
Fast forward to early 2000 and the 10-year government bonds were at 6.6 per cent with CPI at 2.7 per cent (for a real return at 3.9 per cent) while currently these bonds yield 3.07 per cent and CPI is clicking in at 3.7 per cent creating a real rate of return of negative 0.63 per cent. And this is before you factor in taxes.
What happened to bring rates so low?
“With short-term rates now near zero, rates must rise as bond investors are no
longer being fairly compensated.”
PORTFOLIO MANAGER LORNE STEINBERG
According to Lorne Steinberg, portfolio manager of the Steinberg High Yield fund in Montreal, “central bankers in the early 1980s had let inflation get out of control. Inflation was running in the double digits and as a result the price of gold had also risen to $800 which was its all-time high at that time.
“By raising interest rates, a concerted effort was made to lower inflation and get it back under control.”
As inflation declined, central bankers were able to continue lowering interest rates, a trend that has lasted over 30 years as indicative of the falling 10-year bond yields over this period.
According to Steinberg “it is clear the 30-year “bull market” in bonds is coming to an end.
“With short-term rates now near zero, rates must rise,” he continues, “as bond investors are no longer being fairly compensated for the risk of inflation.”
A bull market in bonds means that interest rates are falling and that the corresponding market value of the longer maturity bond is rising.
As interest rates begin to rise, the market prices for these existing bonds will fall. However, higher bond yields translate into an opportunity for new investors with cash to invest as they will receive higher yields on their fixed income investments such as term deposits and annuities.
There are some signs of higher rates are creeping into the landscape when recently we saw the U.S. 10 year benchmark treasury bond yield jump 10 per cent from 2.94 per cent to 3.23 per cent.
This may be more indicative of overall market volatility than an actual trend higher. Yet some banks have already increased their five year mortgage rates.
This does not mean we will be heading back to the heady rates of the 1980s anytime soon. In fact, some economists’ outlook for the next 12 months is for a slight moderation in inflation from current levels back toward the two-per-cent range, and a rise in the 10-year bond rates to somewhere around four per cent.
This would bring real interest rates back into positive territory, at least before taxes. That alone would be a move in the right direction for many fixed income investors.