Pandemic Interest Rates: How Low Can They Go?

The Federal Reserve seems to be signaling that short-term interest rates will remain a fact of life for, perhaps, years to come. Wise? Foolish? Time will tell.

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.” --- Charles Dickens

The Federal Reserve seems to be signaling that short-term interest rates will remain a fact of life for, perhaps, years to come. Wise? Foolish? Time will tell. But what does a lengthy period of near-zero interest rates mean to folks in the here and now? Well, like most things, it depends.

Predictable Patterns

The 10 Year Treasury is the benchmark used to decide mortgage rates across the U.S. and is the most liquid and widely traded bond in the world. The current 10 Year Treasury yield as of September 21, 2020 was 0.68%. On September 21, 1981, it peaked at 15.68%. Except for its recent plunge, the 10 Year Treasury posted its lowest rate of 1.46% on July 25, 2016. Currently, interest rates are at levels not “enjoyed” for over 50 years. Predictably, low interest rates encourage folks to buy homes or refinance old mortgages carrying higher rates of interest. In the current environment, mortgage rates will likely remain low.

This should be a benefit to home builders as well as to families either downsizing or cashing in home equity for retirement purposes. Low rates have already spurred major refinancing - an activity that will run its own course in time – and also because many banks are setting refinance rates higher than that for mortgages. It stands to reason that folks with excellent credit will benefit the most from low interest rates. But if lending institutions as many predict tighten lending practices, those viewed as credit risks will be left with fewer options to finance their endeavors.

Costs and Benefits

Those among us who save, invest, and occasionally lend, could both benefit AND suffer in a persistent low rate environment. The more well-to-do savers…those most likely to lend to lend to entrepreneurs…will have less incentive to do so, increasing the difficulty of risk takers to find backers for their bold new ideas. For older folk, it could mean delaying retirement and for younger adults, delaying or bypassing higher education. Equity investors could benefit as conservative bond holders among us seek higher yields elsewhere, providing additional support to the stock market. In short, it really depends on where a company, a family, or an individual falls on the financial continuum.

Some Will Suffer

Those risk-averse holders of cash or folks who traditionally hold assets that produce a steady income stream (i.e., retirees) will likely suffer in this low rate environment. And folks who invest in what I call “shifting asset accounts,” like 529 education funds and target-date retirement funds that reallocate to bonds as college or retirement milestones approach, will experience lower yields, and thus less income from those assets.

These diminished streams of income will inevitably encourage investors to consider tradeoffs. Due to lowering rates, if a 529 account does not generate sufficient funds to send a child to college, should that child’s education be delayed? If not, are other funding opportunities available? Will parents consider less expensive colleges and universities viable options? Are low-interest student loans available? If so, are they financeable? Delaying the education of a child comes with its own set of opportunity costs…primarily the loss of incremental future earnings.

Delaying retirement – whether early or not – may be an even bigger issue because of the sheer numbers of people involved. It’s virtually inevitable that people will be saving (and earning) less money in 401(k)s, 403(b)s, 457(b)s, IRAs, and other retirement vehicles…or perhaps having to take Social Security benefits earlier than planned, reducing long-term inflation-adjusted monthly income for life. Without question, those dependent on interest income or who planned on interest income being a significant part of their cash flow for whatever reason, will suffer from an extended low interest rate environment.

Silver Linings?

Aside from reduced mortgage and refinance rates in housing, where might we look for silver linings? Will credit card interest rates drop? Millions of folks are dependent on credit cards to get them through unexpected cash crunches; thus, reduced credit card rates would be a Godsend…if they happen. But experts predict “perhaps down a little, but not likely much.” Financial institutions are very hesitant to reduce credit card rates due to the traditional high loss factor. In light of that, low interest rates in general might actually motivate folks to create or beef up their emergency funds instead of relying too heavily on credit cards as a fallback position. Those who already park cash in such easily accessible accounts will be quite comfortable with Rainy Day fund rates, which are typically held in low-yield accounts.

A low interest rate environment will likely tempt folks to assume more risk in their investing. Many believe, including me, that today’s strong market is in no small part the result of people chasing yield…often without being mindful of the associated risk. A Fed-induced low interest rate environment, in addition to helping the federal government finance its staggering debt, is designed to encourage us to spend more and invest in riskier assets. Low rates induce that sort of behavior.

Vulnerable Retirees

Probably those who are most vulnerable to the negative impact of a low interest rate environment are retirees or those approaching retirement. Historically, this risk-averse group has relied more heavily on investments in bonds or bond-like instruments for income. Loss of those once-comforting bonds yields, the replacement of company pension funds by employee-directed 401(k)s, etc., and the looming threat of reduced Social Security benefits have been reinforced by Fed action in recent years and is expected to continue for the foreseeable future.