What low interest rates mean for you

I’ve been talking non-stop interest rates and monetary policy for the last few days.

I’ve been talking non-stop interest rates and monetary policy for the last few days.

On Wednesday I said the Bank of England has less control over interest rates than you might think. I said Mark Carney can steer interest rates the same way a bus driver can steer off the road — technically true, but not really the point.

Yesterday I talked about the real determinate of interest rates: the supply of savings and demand for borrowing. The interest rate is the number that keeps those two forces in balance. I said interest rates have been falling since roughly 1980 — and not because central banks have told them to.

Interest rates have been falling because a) inflation has fallen, b) people are saving more for retirement, which boosts the supply of savings and c) China has gotten a lot richer, and Chinese people tend to save about 40% of their income. All those forces have pushed interest rates right down since the 80s, when they averaged around 5%.

I said we shouldn’t expect interest rates to go up much further. Three reasons: one, we’re still not over the demographic hump, and people are still saving very hard for retirement; two, new banking regulations force banks to hold safe low-interest assets; three, there’s no sign of inflation. Rates might rise a bit, but I don’t expect we’re headed back to the 1980s.

So we’re probably in a low-rate world for the foreseeable future. What does this mean for you?

A couple of consequences. One, interest rates have a bearing on stock prices. According to what’s called the “Fed model”, stock and bond prices move together. The model compares the yield on stocks to the yield on government bonds (which is basically the interest rate). When the yield on bonds (ie the interest rate) goes down, the yield on stocks goes down too. And another way of saying “the yield on stocks goes down” is to say “the price of stocks goes up” or “stock multiples go up”. And that’s exactly what we’ve seen — stock market pe multiples are at record highs.

The implication for you: as long as we’re in a low interest rate world, expect high stock multiples. Don’t be freaked out if multiples are above historical averages. They’ll stay high as long as interest rates stay low.

Another consequence of low interest rates: high house prices. Low interest rates feed directly into house prices by making any given mortgage cheaper to finance. People respond by taking out bigger mortgages and paying more for houses. So higher rates would certainly lower house prices — but higher rates wouldn’t make house prices more affordable. Higher rates would make bigger mortgages less affordable, which would lower house prices. But home buyers would be in the same position. They’d be taking out the biggest mortgage they can afford. In a world of low interest rates this means an expensive house with cheap financing; in a world of higher interest rates this means a cheaper house with expensive financing. They don’t come out ahead.

Another consequence of low interest rates: foreign exchange and the stock market. The interplay between interest rates and forex, and the stock market is not straightforward. Beware anyone who tells a simple story about these. A rise in interest rates could send the currency up or down, depending on the overall economy. To go back to the metaphor of Mark Carney driving a bus on a windy road: a rise in interest rates which keeps the bus on the road would be received very differently by the stock and forex markets, than a rise in interest rates which crashes the bus into the inflation ditch, or the recession ditch.

One thing to keep in mind is that the biggest companies in the UK are unusually international. The FTSE 100 is dominated by giants which make most of their money overseas. So the FTSE 100 in particular is very sensitive to the exchange rate. When sterling falls, as it did last year, the FTSE will go up for no other reason than the sterling value of overseas earnings going up.

So ends my interest rates trilogy! To sum up — the Bank of England doesn’t set rates. They’re staying low. And they’re the reason stock prices are high.

My advice is the same as ever — stay in the market! Stocks always win out in the long run.

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