Interest rates are at historic lows, and they are likely to stay that way for a while. They affect nearly every aspect of the financial world, including economic growth, inflation, and stock and bond market performance. So it is important to understand how interest rates affect your investment portfolio and personal balance sheet.
At a high level, we expect the continuing low interest rate environment to benefit the stock market; corporate earnings will be boosted by companies’ ability to borrow at attractive rates as well as by increased consumer spending. Meanwhile, return expectations for bonds and other fixed income assets are quite meager. In terms of personal finance, low interest rates can also benefit individuals and households by lowering borrowing costs and making large purchases more affordable.
Against this backdrop, we provide perspective on how investors may be able to take advantage of historically low interest rates — as well as some important pitfalls to avoid.
What led to the lower for longer environment?
The U.S. Federal Reserve has been focused on reducing interest rates and keeping them low since the global financial crisis (GFC) of 2007–2008. Low interest rates were needed during the GFC to ensure that the financial system continued to function properly —and to spur economic growth. Even though the U.S. economy has grown for much of the past decade, inflation has remained low. This has allowed the Fed to keep interest rates relatively low, while gradually increasing them from 2016 through mid-2019. The Fed began to lower interest rates in mid-2019 due to rising international trade tensions and slowing economic growth.
When the COVID-19 pandemic hit in early 2020, the Fed quickly slashed interest rates to combat the pandemic’s drastic impact on economic growth. The Fed has signaled that it plans to keep rates low for the foreseeable future, even if this policy leads to higher inflation than what the Fed typically targets, to help maintain the momentum of an economic recovery.
How do interest rates affect businesses and investors?
Generally, low interest rates are beneficial for businesses. Low borrowing costs help companies expand operations, hire more workers, and make other investments that can increase profitability. These capital investments are more attractive when interest rates are low because businesses can more easily earn a return that exceeds the interest rate on the borrowed funds.
The low interest rate environment has helped to fuel returns for equities and fixed income investments. As rates decline, the fixed interest rates bond holders receive become more attractive, driving up demand and the price of the bond. For the most part, bond holders have benefited from declining interest rates over the past three decades. But now that U.S. interest rates are so close to 0% (10-year US Treasury bonds are yielding 1.15% as of January 11, 2021), there is limited upside potential for bond holders. Rates have gone into negative territory in other developed economies, but we don’t think this is likely to happen in the United States.
Stocks generally benefit from low interest rates in several ways. Not only are businesses helped by having a lower cost of capital (as described above), low interest rates also spur consumer spending, which is a major driver of economic growth. In addition, low interest rates generally make stocks more attractive than bonds on a relative basis. When bonds are yielding very little, investors are more inclined to invest in stocks; this provides a further tailwind for equity markets.
A sustained low interest rate environment can also create risks for investors. Given the relatively low yields offered by traditional bonds, investors may be tempted to reach for higher-yielding securities, such as high-yield corporate debt. But investors who chase yield may take on unintended risk. In addition to the increased risk that lower-quality issuers may default on their debt, “junk” bonds or other types of high-yield debt provide less equity diversification benefits than higher-quality fixed income securities. This is because when volatility increases and equity markets decline, riskier debt tends to perform more in line with equities.
Persistently low rates may tempt investors to chase performance in stocks as well. Investors looking to boost their portfolio’s returns may gravitate to riskier, high-growth segments of the economy or stocks paying relatively high dividends. It is worth noting that stock market valuations are relatively high now, and these types of stocks are more susceptible to a market correction than more stable companies with defensible market positions.
What does the low-rate environment mean for you?
The potential benefits of low interest rates are not isolated to investors’ portfolios. Low rates can help your personal balance sheet, as well. Most notably, low rates make it relatively more attractive for individuals to finance a large purchase, refinance a mortgage, or take out a home equity line of credit.
As financial advisors, we typically encourage our clients to reduce their debt loads rather than take on additional debt. But with interest rates at historically low levels, there may be advantages to rethinking this strategy to take advantage of today’s unique environment.
Are you interested in learning what low interest rates mean for you and your family? Please schedule a time to talk with our team at Leelyn Smith about ways to strengthen your finances in today’s environment.