If you haven’t been paying attention to financial news lately, you may be wondering why interest rates are so low.
Interest rates are historically low, and have been for several years. In fact, for the last 2 decades, the Federal Reserve Board (FRB) has been keeping the Discount Rate historically low to help stimulate the economy. The Discount Rate is the interest rate the Federal Reserve, the central banking system of the United States, will charge on loans to member banks and this rate in turn drives all other lending rates.
In addition to keeping their Discount Rate low, ‘The Fed’ has also recently been expanding the money supply by purchasing securities like US Treasuries in what is known as “quantitative easing”. This quantitative easing was increased in response to the COVID-19 pandemic as a way to make more low-interest cash available to (small) businesses and individuals so they could weather the pandemic storm.
The Fed will eventually need to increase the Discount Rate and sell the securities in what is called ‘quantitative tightening’ but that could be several years from now once the nation has fully recovered from the pandemic. When that happens, interest rates should begin to rise.
Interest Rates and Fixed Income Options
What this means for investors trying to Grow the money they Save, is that it has become more difficult to generate a meaningful return on savings accounts, money-market products and other fixed-income assets. Fixed income assets include lower risk securities like US treasuries (T-bills, T-notes, T-bonds & TIPS) and investment-grade corporate bonds that pay regular interest to the holder.
Currently, the yield, or interest rate, on a 10-year treasury note is 1.345%. The chart below shows the steady decline of this yield since 2000.
This means that if a 10-year T-note was purchased today at the standard $1,000 face value and the coupon rate equaled the current yield, it would pay out $6.725 every 6 months ($13.45 annually). Not a huge return by any means but better than zero.
Most savings accounts at banks are paying less than 1% annually. Corporate bonds, which are considered higher risk, might offer slightly better yields than treasuries. But, in general, none of these options are exceeding historical inflation rates (2-3% per year) so purchasing power is actually declining with these investments.
Impact on the Equity (Stock) Markets
These low interest have made equity securities (stocks) attractive for 2 primary reasons –
- Investors are willing to forego the additional risk for the opportunity to earn significantly higher returns as compared to fixed-income securities.
- The price of a stock is largely determined by the present value of its future earnings. With interest rates so low, those future cash flows, whether in the form of dividends paid to stock holders or retained earnings, are discounted less thus driving up the price of the stock.
When rates do begin to rise, which they eventually will since no further downside is available for the Fed with respect to the Discount Rate, there will most likely be a negative impact on the stock market for the same 2 reasons as above but in reverse. Fixed income securities will begin to look more competitive from a risk/reward perspective and the future earnings will be discounted more thus driving stock valuations down.
For most investors trying to balance risk and return for their overall retirement portfolio, a diversified approach is recommended. For example, someone nearing the start of their retirement might allocate 10% of their retirement portfolio to cash for liquidity and emergencies, 60% to fixed-income and 30% towards equities. But within each of these allocations, what are the best specific fixed income or equities to hold?
We Can Help
The financial professionals at Monument Financial Group can help you identify options for your diversified allocation ‘buckets’ that will help you meet and exceed your financial goals. With our education-based approach focused on long-term client success, we will help you identify the short-list of options within each allocation. This approach, along with periodic reviews and adjustments, will keep you on-target to Save-Grow-Protect for your financial future.
Call 719-453-1853 to get started today with your free initial consultation.
UPDATE: Feb 27, 2021
This past week, the benchmark 10-year yield, which influences mortgages and other loans, was at 1.46% , about 15 basis points [0.15%] above the level it was at just a week earlier. After a big surge on Thursday February 25th, the 10-year yield traded on both sides of 1.50%, which is the consensus view of where yields would be at the end of the year, not the beginning.
The expected economic boost from the next round of stimulus is driving yields higher. There are also heightened concerns about inflation so higher interest rates will help offset that.