Fill your boots….the world of falling interest rates

We have effectively entered the parallel universe and we really don’t know what the future will look like.

If I was writing this blog on the 31st May 2016, I would be saying that the last time interest rates went up was in July 2007, and since then they had fallen and settled at the ultra-low level of 0.5%. With the improvement in the UK economy it seemed likely that in 2016 or 2017 we would see interest rates rise, with many predicting that over the next five years’ rates would settle in the region of 2 to 3%.

So what would this have meant?

Rising rates

To put all of this in context it is worth remembering the UK economy (like the rest of the global economy) was in a low growth environment. This didn’t mean there was a recession around the corner but it did mean that careful management of the economy was needed. In simple terms rates were set to rise to counter inflation and to reflect an improving economy. But the increases would be slow and steady to reflect the slow growth, and not upset a fragile economy.

When rates rise it impacts several areas, some key examples include:

  1. Cash – for those holding cash, ultra-low interest rates have meant that interest paid has been negligible. In theory investors in cash have had to adapt and actively manage their cash to find the best rates but sadly the reality is that many have failed to do this, and there isn’t a lot available offering decent rates. The need to actively manage cash doesn’t change but when rates go up it should make it easier to find better savings rates. This is because there is a direct correlation between interest and savings rates, if interest rates go up so do saving rates. So savers win in this situation.
  2. Mortgages – the cost of mortgages go up and this has a ripple effect. The main impact is on the economy because people have less money, which means they have less to spend. It also slows down the housing market; because as mortgage costs go up so the demand for houses falls and so house prices start to decrease, which is good news when the market is overheating. So this can be mixed for people with mortgages and buying property.
  3. Bonds – these are often seen as the next step up from cash and many mistake them as safe investments. These are debt issued by governments and companies. The price of a bond is driven by market interest rates. These in turn are driven by a number of factors but as an example where there is weak economic data, the market will price-in a fall in interest rates, conversely when the data is positive they price-in a rise. So if rates rise and the market prices in further rises, then the price of bonds fall. So rising interest rates are not good for investors in bonds.
  4. Loans – lending is an important part of the economy; people will borrow for all sorts of reasons. One of the major growth areas is car ownership, if rates go up then the cost of borrowing goes up and like mortgages there is a potential slowdown.

These are only some of the risks and when the economy is fragile the Bank of England must juggle the economy, with a material need to raise interest rates (to keep inflation in check) but at the same time ensure that they are not strangling growth by raising rates too much.

Sliding doors

For those familiar with the film “Sliding Doors” Helen gets fired from her public relations job and as she leaves the office building, she drops an earring in the lift and a man picks it up for her. She rushes for her train and misses it.

At that point the plot splits in two parallel universes; one detailing what would have happen if she hadn’t caught the train and the other detailing what would have happened had she caught it.

Fast forward to 23 June, and we have a similar moment. Up to that point we had an idea of what the future held but suddenly everything changed. We have effectively entered the parallel universe and we really don’t know what the future will look like.

Falling Rates

With the vote to leave the EU, everything changed and it seemed that interest rates would go down (and market interest rates reflected this). In August the Bank of England cut rates to 0.25%. Moving forward, interest rates could fall further (although there is not much room), and predictions are that rates will not rise for perhaps five years.

There is no doubt that this has been done in part to provide confidence into the UK market, but there are winners and losers in this.

  1. Cash – those with cash were hoping that a rise in rates would start to see growth in saving rates. Now the opposite is true and with the fall in interest rates savings rates are at all-time low with no end in sight. If interest rates don’t change for five years and inflation goes up, then cash will continue to be a negative producing investment in real terms.
  2. Mortgages – the cost of mortgages goes down and we have already seen fixed rates fall. It also makes the cost of owning a house more affordable for many. Where we have in the past predicted a slowdown in the housing market, this is unlikely to happen to the same degree. There remains other factors with the housing market which may counter cheaper mortgages, for example less demand for buy to let, more stringent affordability checks and re-mortgaging interest only loans.
  3. Bonds – with interest rates falling bonds suddenly look attractive and the price goes up. Anyone investing in bonds this year will have done very well. Bond prices are driven by the market interest rate, and over the next few years particularly in the UK these rates are expected to move a lot, especially when we move closer to exiting the EU. Currently some government bonds are paying zero or negative yields and big swings in prices will makes this more volatile. Some argue that with the low yields and potential volatility bonds will not make an attractive investment moving forward.
  4. Loans – similar to mortgages loans become cheaper, which encourages spending.

What are the risks

Interest rates have been ultra-low for nearly ten years; and if they don’t increase for five years we could be looking at 15 years of interest rates at or below 0.5%.

This means there is a whole generation of people who only know about low rates. When interest rates go up (and they will eventually) this could create a bigger slowdown than anyone is expecting.

For example, if mortgage rates have been 0.25% and they go up to say 3.00%, that could be a near 40% increase in monthly outgoings. When you take into account other factors like personal lending it could make it very hard for people to manage finances in future.

Where you have never experienced a rising interest rate environment, even small increases can lead to defaults on mortgages and loans, which is not good for the economy.

Fill your boots

An interest rate rise of 0.25% seems amazingly attractive and it opens up opportunities that perhaps weren’t there before but things can change rapidly. Turning back to Sliding Doors, if we read the papers everything is very rosy in the UK economy and therefore we can assume that not much will change in the near future.

There is a very good reason for this, the UK is currently still a member of the EU and is likely to be for the next three years meaning that we continue to benefit from trade deals. Secondly the UK is an attractive place to invest; sterling has fallen which benefits exports and investing in UK firms because everything is cheaper. But this may be short term.

No-one knows the future, and what happens with interest rates is uncertain. They could go down; they may not go up for five years. This is a bold statement but perhaps we could see interest rates at this level for ten years.

What we do know is like the movie there were two different outcomes from 23 June. You could argue there was a little bit of certainty with one but there is considerable uncertainty with the other. This therefore makes it very difficult to predicate the future of interest rates over the next ten years and those thinking now is the time to “fill their boots”, while rates are low should be cautious because the future is less than certain.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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