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The Incredible Shrinking Interest Rate

It is no secret. Interest rates have shrunk to microscopic levels. Anyone with excess cash or conservative investments are feeling the struggle to find yield.

Rates have been low before. But not like this.

Professor Robert Shiller tracks stock market valuations and 10-year government interest rates every month. His data set goes back to the year 1871. If you rank his interest rate recordings from lowest to highest and look at the 10 months with the lowest interest rates, five of the 10 are from the year 2020. The top four lowest recordings in history are all from months in 2020. And the year is only halfway over.

Rates are at rock-bottom.

In Europe and around the globe, rates have turned negative. Think about that. Instead of the bank paying you interest on your savings, you pay the bank for the pleasure of holding your money.

Don’t blame your bank, though. It is only working with what it has been given. The Federal Reserve is where it all starts. That institution sets the pace for the U.S. monetary system. And right now, the Federal Reserve is doing everything it can to combat the economic slowdown related to the pandemic.

By lowering interest rates, the Federal Reserve reasons, people should avoid saving and start spending. After all, if you are not being paid much in interest on your savings, then why keep saving?

Low interest rates may be bad for savers, but they are wonderful for borrowers. By lowering interest rates, the Federal Reserve also hopes to juice the economy through borrowing. More people buying more things is good for economic activity.

For savers, however, low rates are painful.

The question is how long will rates remain at these levels? That is a question without an answer. People may estimate, guess, predict – call it what you will – but no one knows for sure. It partly depends on overcoming the fear of the coronavirus and partly on the Federal Reserve’s reactions to future developments.

But what if rates are low for a long time? What does it mean for savers and investors?

It means asset prices may get distorted. It means money will flow to the pockets of opportunity with the greatest chance of offering yield and return. It means risk may become underappreciated.

For instance, taking out a certificate of deposit or buying a short-term bond offers limited returns today. You are likely looking at an interest rate below 1%. The dividend on the S&P 500, which is a benchmark for 500 of the largest companies in the U.S., has a dividend yield of 2% today. That’s at least twice as much as a CD or short-term bond. But investing in stocks comes with significantly more risk.

By decreasing interest rates, the Federal Reserve is pushing more people to purchase riskier assets. That may keep the stock market chugging higher for a time. But it also may not end well. As they say, what the wise person does in the beginning, the fool does in the end.

Another potential implication of “lower for longer” may be a surge in real estate values. With less volatility than the stock market and potentially higher yields than CDs and bonds, investors may find residential housing, commercial buildings, and farmland as better places for their money.

The Wall Street Journal produced an article several years ago, discussing negative rates in Europe. It blamed the interest rate environment for overbuilding in the real estate sector. The paper quoted the head of the Swiss Bankers Association, who said, “Holding cash is simply more expensive than building an empty house.”

Let’s hope that’s not where we are headed.

Eventually our economic system will heal itself. Until then, be careful. Avoid taking more risk than you can manage just to earn a little more return. It may work for a while – until it doesn’t.

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