Your mortgage, your pension, your savings, your investments. The prospects for all these have changed significantly as the financial world appears to be turning upside down. Interest rates on many products are now zero, or negative, share prices have swung nervously and have been on a downward trend. So what do these big trends mean for your finances ?
THE CONTEXT
The economic crisis which hit in 2008 may be over but its after-effects linger on. During the crisis the world's central banks cut interest rates to unprecedented lows to try to stave off a collapse into a cycle of low growth and even deflation – where prices fall. But since the crisis growth has been patchy, at best, across the industrialised world. And so interest rates have remained at rock-bottom levels. The US central bank -– the Fed – did manage to increase its key interest rates to close to 2.5 per cent. But this is just half the rate they peaked at in 2007 and because growth is slowing the Fed has now been forced to actually cut rates by 0.25 of a percentage point and there is talk of more to come. Meanwhile, the European Central Bank (ECB) has not been able to increase its base rate above zero and actually operates a negative rate for banks depositing overnight cash, meaning they pay the ECB. And now it, too, has said it will examine if it needs to reduce rates further and may do so in September.
In the US, short-term interest rates are now above long-term term rates
This is happening as key market signals and data point to the risk of a US recession and very slow growth in Europe. In the US, short-term interest rates are now above long-term term rates, a reversal of the norm and generally a signal that a recession is likely in the coming year. This is called an inverted yield curve in market jargon.
In Europe, the German economy shrank in the second quarter and confidence indicators are on the floor. Meanwhile, the UK is facing into Brexit with its own recession fears. This all means downward pressure will remain on interest rates in the months ahead and equity markets look set to remain rocky. With investors fleeing more risky investments, nerves are rattled.
THE IMPACT
1. For borrowers
This has created an extraordinary situation for borrowers .The outlook for interest rates could hardly be better. Here, expectations at the start of the year that variable mortgage rates could start to increase before the end of 2019 have been well and truly shelved. The key thing for longer-term borrowers ,such as those with mortgages, is that the period of super-low rates is here to stay – for the next few years anyway. In a normal cycle, ECB rates would start to rise and gradually head to, say 3 per cent to 4 per cent at least. But this now seems a "long, long way away", according to Owen Callan, market analyst at Investec. Investors are starting to ask whether interest rates may remain low for several years to come – as they have for many years in Japan.
The ECB may leave its main refinancing rate where it is – at zero per cent
In the short term the talk is of a further cut in ECB interest rates, though it is not clear yet how this would be managed. The ECB may leave its main refinancing rate where it is – at zero per cent. This is the one which governs tracker mortgage rates. It could cut the deposit rates it pays to banks who deposit overnight funds, already in negative territory at minus 0.4 per cent, possibly with some tweaks to give Europe’s banks some protection.
So mortgage rates here will stay low. We have seen banks nudge down their fixed-rate mortgage offerings – and this may well continue. It remains to be seen if competition can nudge standard variable rates a bit lower.
So while mortgage rates here remains well above the euro zone norm – some banks in Denmark are offering loans at zero or negative rates – in historic terms rates are super-low.
The one question for borrowers, of course, is what the era of low rates and low expectations for growth means for the price of their asset – their house. Already we have seen house prices slow sharply, partly due to affordability but also – we must presume – due to the changing growth outlook and nervousness about Brexit.
2. For depositors
The banks don’t want your deposit. They already have too much cash and nowhere profitable to put it. Normally they would put excess cash into areas such as government bonds and get some return, but with $16 trillion (€14.35 trillion) of the world’s debt now trading at negative interest rates , they have few options here to get any return. The ECB, via its policies, it also pushing them to lend cash and penalising them for hoarding it.
This means there is no chance of any improvement in deposit rates – indeed the banks would surely like to penalise depositors with higher charges or even negative rates if they could, or just tell them to take their money elsewhere.
Banks will still want to hold on to customers – hoping to make money out of them in other ways
Banks are already on the record as discouraging large corporate depositors, according to Callan. Meanwhile regulatory barriers make it difficult for them to increase account charges for personal customers.
Banks will still want to hold on to customers – hoping to make money out of them in other ways. But the current situation presents them with a dilemma, and they are likely to intensify efforts to sell depositors other investment products which, while involving some risk, offer the prospect of some return. And some fees and charges for the bank.
In the old days. the biggest corporate and personal depositors were valued customers. No more. The only consolation is that inflation is also very low – in the Republic, it rose to over 1 per cent earlier this year but fell back to 0.5 per cent recently. This means that the real value of savings are not being eroded – or not too much anyway.
3. For investors
In an era of super-low interest rates, the message central banks are sending is that people should be prepared to look for places to invest, rather than leaving their cash in the bank. But where?
As financial broker Liam Ferguson puts it, there are no easy answers for someone with a lump sum to invest. Cash offers no return and bond markets are already at extraordinary high levels and offer little or no interest rate yield. Even risky Greek 10-year debt is offering a rate of just over 2 per cent. In the long term, you would think bond prices will fall if any inflation returns to the world economy.
Equities are a long-term play for many private investors
This pushes investors towards equities, where fund managers are divided on whether a major correction is on the way as world growth slows, but recent trembles show this is a risk. Equities are a long-term play for many private investors, of course, though Ferguson points out that many major markets have already had an unprecedented 10-year rise. Indeed Irish equities have already suffered – led down by the banks – with the market losing around 12.5 per cent over the past year.
For those already invested in equities, the choice is whether to sit tight or move some funds into cash or other assets. There is no right answer here and Ferguson cautions that experience shows that a investors often clock up losses when they try to time their return to the market after selling. Professional advice is needed, but the context is that for most, equities are bought for the long term and in some cases for steady dividends as well as capital appreciation.
Callan of Investec says big investors are now trying to work out whether we are looking at a short-term “blip” in international growth or something more sustained. This has big implications for equity valuations and, of course, for interest rates.
This environment has left major investors searching for returns – and spurred huge international investment into our commercial property market, for example, and a renewed surge in gold. Irish investors can get exposure via funds or directly to assets such as property and gold, though the usual advice is not to concentrate too much in one area. In short, at the moment, there are no easy answers.
4. For your pension
There are some special issues for pensions. First of all the low interest rate environment will maintain pressure on many defined-benefit funds by increasing the valuation of their liabilities. The move to defined-contribution schemes, where your pension depends on the performance of your fund, will continue, shifting the risk to the individual and away from the company.
Many people are thus choosing to put their pot into an approved retirement fund, which offers more options
For pensioners coming to retirement, the current low interest rate environment pushes them away from taking an annuity – the traditional route for those with pension “pots”. Interest rates on annuities can be as low as 3.5 per cent, according to Ferguson, meaning you would be well into your 90s before you even got your cash back. Many people are thus choosing to put their pot into an approved retirement fund, which offers more options and does not tie into currently very low interest rates.
At a wider level, pension investors have the same issue as more general investors – where to get a return on their cash. Also, what are the implications of the current market upheavals? Many modern funds allow people to manage their own funds, in terms of allocating assets, though of course your fund manager is meant to be the expert here.
Of course the initial returns for pension investors are boosted by tax relief on their contributions. Some of this is clawed back when the income is drawn down, though typically there is still a decent tax advantage overall.
Post retirement, those with approved retirement funds face the same dilemmas of where to get a return. Ferguson says some are choosing to put a portion of their money into buying a rental property, thus generating a return.
