Interest rates are a topic that we have spent a fair amount of time talking about over the last few years. This is for good reason. Interest rates have a profound impact on the financial position of a lot of people.
Most of the bigger purchases in life (i.e., house, car, school, etc.) are impacted by interest rates. This is fairly easy to understand. Lower interest rates mean it’s cheaper to borrow money, and vice verse.
Below we look at the following: A overview of interest rates, the future of interest rates, and how low interest rates affect savers. At the end of the article, you can find some of our older pieces on interest rates.
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Interest Rates
Over the course of history interest rates have fluctuated a lot. As the economy hits bad times, interest rates generally decline. As the economy steams ahead in good times, interest rates generally rise.
There are two interest rates that you should be aware of: Prime and Overnight. The overnight (or bank rate) interest rate is the rate that big banks use to lend money to each other in the short term, usually overnight. Prime Rate is the interest rate that banks charge retail clients. Prime is based on the overnight rate.
Currently, the prime lending rate (the base rate you get when you go to the bank) is sitting at 2.45%. The current bank rate is sitting at 0.25%.
Going back more than 85 years, you can see that our current 2.45% prime rate is only 0.20% higher than the rates experienced around the 2008 global financial crisis. The current bank rate, which only started in 1996, is just as low as during the financial crisis.
Based on historic data provided by ratehub.com, we created the following graphs showing the trends and average of both prime and the bank rate.
The average Prime rate over the last 85 years is just under 4.20%. That is nearly 1.75% higher than the current rate. If we take out the last 12 years of historically low rates (2009-present), the average prime rate jumps to just over 5.8%.
The average bank rate going back to 2003, is 1.63%. Nearly 1.4% higher than the current rate.
Interest Rates Set to Remain Low
It is not a secret that 2020 has not treated the economy very well. Due to the current economic landscape, it’s no surprise that rates are set to remain low.
In the most recent meeting, the Bank of Canada reported that it was leaving the overnight rate at 0.25%. The policymakers also promised to keep the benchmark there until unemployment falls closer to pre-pandemic levels and inflation returns to their 2% target.
So, going off employment and inflation forecasts, that would suggest rates will remain flat until after 2022. The goal is to have low rates spur the economy and increase business and consumer spending.
Almost a year ago we wrote a piece on how interest rate cuts may not be the answer this time around. In that article, we explain how, because interest rates have been so low for so long, the incentives that come with lowering interest rates have diminished.
Throughout history, a lot of the bigger consumer and business purchases and expenditures have been reserved for when interest rates decline. However, as shown in the graph above, we have had rates below the historic average since 2008. Due to that, consumers and businesses have not been holding off on their larger purchases.
What Low Interest Rates Mean for You
As we have mentioned before, low interest rates have their pros and cons. In general, they penalize savers and incentive spenders.
Penalize Savers
When interest rates are low it is easier to access capital. The cost of borrowing is greatly reduced so its easier to afford bigger items like houses, cars, appliances, vacations, etc.
However, that also means that savings rates are greatly decreased. Although stock market returns aren’t linked to interest rates, what is referred to as the risk-free rate of return, is.
The risk-free rate of return is the return of an investment with zero risks. The investment with the least amount of risk is a Treasury bond (i.e., T-Bill). The risk-free RoR is calculated by subtracting the current inflation rate from the yield of the bond.
Bond yields are correlated with interest rates. As rates rise, so do yields. As rates fall, you guessed it, so do yields.
Below there are three charts. One showing the 10-year Canadian Treasury Bond yield since January of 1960. The second showing a historic prime rate over that same period. The last is the two charts overlaid to show the correlation.
Looking at the 10yr bond yield, the past yields seem hard to believe. If you look at the late 60s to early 90s you were essentially guaranteed an 8% rate of return not accounting for inflation. The bond yield topped out at 17% in September of 1981.
Between 1969 and 1992, the average 10-year bond yield was 9.82%. During that same time period, the average inflation was 6.43%. That’s a risk-free rate of return of 3.39%.
Since 2010, the average 10-year bond yield has been 2.02%. Over that same time inflation has averaged 1.74%. That makes for a risk-free RoR of a whole 0.28%.
However, if you believe that inflation has actually been that low over the last decade-plus, we would encourage you to read Inflation Is Higher Than You Think.
If your investment advisor wasn’t able to generate a return in excess of 8% between the 60s and 90s, they probably weren’t worth it. Today, if your advisor achieves an average of 8%, we would say they have done very well.
With the risk-free rate of return being so high, savers nest eggs grew extremely fast. For example, $100,000 generating 6% over 30 years would leave you with nearly $575,000. That’s a return nearly 5.5% higher than the current 10yr bond yield.
That same $100,000 generating 13.5% (5.5% higher than the minimum 8% between the 60s-90s) over 30 years would leave you with $4,465,559. It is no surprise that the baby boom generation was able to build such immense wealth.
It is important to note that inflation was not accounted for in the calculation above. Inflation would lower the return, but this calculation was to show how low interest rate affects savers.
Conclusion
In the end, there is not much we can do to control rates. We have had more than a decade of historically low rates, and it doesn’t look like that will change.
However, what we can do is educate ourselves. We can learn how rates affect our purchases. Why low rates are used during downturns. The effect that low rates have on your savings.
By understanding some of the more nitty-gritty details we can better position ourselves. Sit down with your financial advisor. Make sure that you are getting the most out of what the economy currently has to offer you.
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Sources:
https://www.inflation.eu/inflation-rates/canada/historic-inflation/cpi-inflation-canada.aspx
