You probably don’t need me to tell you that interest rates are very low right now. In fact, interest rates are around 5,000-year lows:

That graph was devised by Andy Haldane, chief economist at the Bank of England, and circulated in October 2015. Since then both the red and blue lines have dived even closer towards (or in some countries below) the 0% flat line.

Such extremely low interest rates across the developed world are due to a number of factors, most directly the near-zero benchmark rates set by central banks.

In August the Bank of England cut its Bank Rate to just 0.25% in response to the UK’s vote to Brexit. An unimaginably low rate got even lower.

Central bank policy plays a huge role in setting wider interest rates by influencing what’s called the yield curve – strictly a representation of the yield you’ll get for holding bonds of lengthening maturities, but often applied to the returns from other asset classes, too.

You can see a central bank’s influence in the lower interest rates on mortgages, savings bonds, and even Santander’s popular 1-2-3 account that followed in the days and weeks after the Bank of England’s cut.

But the Bank of England had its reasons for further cutting rates, of course, and for having held its rate so low for so long in the first place.

And these reasons give us a clue as to some of the fundamental drivers of today’s very low interest rates.

The interest rate merry-go-round

This is not a Phd thesis on rates, so I will have to be necessarily brief.

Indeed I am writing this article at the request of a few readers who have asked for a super-straightforward summary of the problems potentially caused by low interest rates.

I don’t want to go off into the weeds!

So with a bird’s eye view, other factors that influence the market interest rates that we as consumers and businesses see (and that feedback into the benchmark rate-setting of central banks) include the state of the economy, inflation and deflation, currency moves, what other countries’ central banks are doing, demographics, and – I’d argue – the emotional state of savers, borrowers, and investors, and the impact of such emotions on asset prices.

There are also more contemporary or controversial causes of low interest rates. These might currently include globalization pulling down wages worldwide and boosting the supply of global savings, or the rise of robot workers. However these factors still manifest themselves as, say, deflation or as low government bond yields.

In fact all these factors interact with each other.

For instance, the economy may take a hit, confidence falter, the stock market plunge, and demand by borrowers for credit slump. A central bank might then cut interest rates to try to stimulate the economy by making money cheaper, and so encourage more borrowing.

Similarly, when the economy is very strong, investors are going crazy, borrowing is at all-time highs, and the central bank fears excess demand could provoke inflation, it might raise its benchmark rate to try to dampen all those factors.

By raising and lowering interest rates like this, the central bank is aiming to dampen the extremes of the economic cycle.

A key thing to remember though is that central banks do not set market interest rates; rather their own reference rate and any associated monetary operations influence market rates, and are influenced by them.

The great rate debate

So how do we square those dynamics with today’s economic picture?

Bank Rate in the UK is at an all-time low, yet few would say the economy is the worst it’s ever been, or investors at their most depressed.

Well readers, that is the $10 trillion question.

People have been arguing about near-zero interest rates ever since the financial crisis ushered them in for the UK, the US, and Europe (with Japan having had very low interest rates long before then).

Central banks initially slashed rates in direct response to the value destruction of the financial crisis, which wiped trillions off asset prices and caused a surge in unemployment and fearfulness that threatened to submerge the world in an economic depression.

Supporters of the extremely low interest rate strategy – and its bedfellow, quantitative easing – claim lackluster economic growth and the absence of high inflation since the near-zero rate era began shows that continuing with such low rates has been appropriate, that things would have been much worse without them, and that fears of an inflationary spiral have proven groundless.

Critics respond with three main lines of attack.

Firstly, they say inflation has been caused by low interest rates, only it’s shown up in asset prices rather than in shopping baskets, with the price of everything from bonds, shares, and property to art and collectibles soaring.

Secondly, they argue a broader inflationary shock has been stored up for the future. It’s like shaking a ketchup bottle, where nothing comes for ages and then it all splurges out at once. Just wait, they say.

Thirdly, many contend near-zero interest rates may have become part of the problem, rather than the solution.

The theory here is that because there’s little penalty now for being a poorly run and indebted business – because you can limp along thanks to cheap financing – low interest rates may be gumming up efficiency and productivity growth, and inhibiting the creative destruction that enables superior companies to grow at the expense of their weaker rivals.

In addition, we might ask what kind of a signal do super low interest rates really send?

If your doctor told you after a heart operation that you needed to trundle around with a bleeping heart monitor next to you all day, you may well feel more nervous – even if the pattern of bleeping suggested you were actually returning to health.

Perhaps something similar is happening in our minds due to seeing low interest rates for years on end? We’re told things are improving, but maybe we’re skeptical because of the low rates themselves, and so we don’t borrow and spend as much as theory would predict.

If that’s true then low rates could actually be dampening the economy rather than helping spark it into life.

There are other potential downsides to very low interest rates, such as if they encourage people to chase higher returns through unsuitable investments.

But then that is partly what central banks are trying to achieve – by trying to get crisis-scarred savers out of cash and into more productive assets, others out of bonds and into equities, and so on.

To an extent it’s not a flaw so much as a feature.

Right and wrong

These debates have been swirling for years in the business media and among sophisticated investors.

For example, CNBC’s recent Delivering Alpha conference was pretty much a procession of hedge fund managers saying a bond and equity crash was imminent because of all the problems caused by low interest rates.

Such comments are also voiced beneath almost any article we publish on Monevator that’s to do with bonds or cash.

And newsletters and rent-a-doomster media pundits have been warning of an imminent market implosion or inflationary shock for years.

I understand where such sentiments come from. The rally that has sent the yields on trillions of dollars worth of government bonds into value-destroying negative territory is hard to square with good financial governance, or even a nodding acquaintance with economic reality.

Yet you have to remember most such warnings have proven wide of the mark for years.

In reality, inflation has stayed low, bond and equity prices have continued to rise, and the UK and US economies have grown and seen unemployment steadily fall (albeit with little in the way of wage or productivity growth).

Yet in spite of such progress, many hedge funds have delivered lousy returns since the financial crisis. One reason is they were too timid because of their disquiet at the low interest rate policy of central banks.

I’m not immune to this. While I spend much of my time warning passive investors in our comments not to suddenly start thinking they’re fortune tellers and dumping all their bonds and whatnot, I’ve had my own hunches.

I thought quantitative easing would cause inflation, and so far it hasn’t. I suspected interest rates would fall back in 2008, but I never thought they’d still be so low eight years later. I also thought bonds were finally topping out in 2015, and was wrong. (Worse, I’d had doubts years before that).

None of which is to say the dire warnings won’t eventually come true.

Markets always crash eventually, that’s nailed-on – it’s the timing that’s difficult – and I also think it’s very hard to believe that a growing global population on a finite planet will never see inflation again, even with all those robots doing jobs at slave labour rates.

But I would add that nearly ten years of seeing doomsters confounded should, at the least, be a reminder to the rest of us to stay humble and avoid hubris.

Everyone has been wrong about this stuff for years.

The optimists thought the economy would respond more quickly to low interest rates and that rates would be back to more normal levels by now.

The pessimists predicted we’d be using a wheelbarrow to take our shopping money to Tesco.

I think pragmatic investors who admitted they didn’t know how things would pan out and so stuck to their plans – and their diversified multi-asset portfolios – have carried the day on points.

Sure, they were never going to make the headlines.

But they’ve quietly achieved good gains, suffered lower levels of angst, and had less need to wipe egg off their faces every six months.

Is the tide turning for the low interest rate strategy?

The readers who suggested this as an article topic said they hadn’t seen much comment about the downsides of low interest rates.

I presume they’ve only been reading personal finance blogs and otherwise getting on with their life (and I applaud them for it) because I have read literally hundreds of thousands of words on the subject over the past few years.

I’m tempted to do a bit of post-crisis doomster bingo (hot words and phrases including the likes of manipulation, confiscation, helicopter money, Fiat currencies, ZIRP, the monetary laboratory, John Law, and gold, gold, gold) but I want to keep things simple and succinct, to honour that reader request.

So having set the scene as to why we have low interest rates, next week we’ll consider what specific potential problems such low rates may be causing that we as armchair investors need to worry about.

After all, there seem to be increasing signs that even central bankers fear we’re running out of road when it comes to very low rates.

The politicians who have hitherto been happy to let central banks carry the load are also showing signs of changing their tune.

Consider these recent words from Prime Minister Theresa May:

“While monetary policy – with super-low interest rates and quantitative easing – provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side effects.

People with assets have got richer. People without them have suffered. People with mortgages have found their debts cheaper. People with savings have found themselves poorer.

A change has got to come. And we are going to deliver it.“

• Update: See part two for a look at the potential problems caused by low interest rates.

The early Autumn heatwave is hotting up the Slow and Steady portfolio as much as the jumpy squirrels in my garden. Should we bask awhile in the good times or should we scurry – gathering more acorns to guard against the inevitable chill ahead?

Okay, let’s bask. After last quarter’s Brexit bounce put us up 10% in three months, we’ve popped on a further 7% since July. It’s lucky the forecasters aren’t paid by results.

The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000 and an extra £880 is invested every quarter into a diversified set of index funds, heavily tilted towards equities. You can read the origin story and catch up on all the previous passive portfolio posts here.

The Slow and Steady is up 22% in 2016, and 27% in the last 12 months. I don’t know how your personal portfolios look, but if you’ve enjoyed similar gains and have tucked away a substantial amount then you’ll have noticed a surprising swelling in your wealth.

Over a longer timeframe the Slow and Steady portfolio is trimmed back to 13% annualised over three years, and 11.5% annualised since we gunned its engines at the start of 2011. Still, that will do nicely!

Here’s the portfolio latest in spreadsheet-o-vision:

It’s adding up. Our portfolio has swollen 44% since 2011. We’ve put in a notional £20,770, versus its current worth of £29,992.

We’re not doing anything clever here. Nothing out of character. We’re just rigorously sticking to a standard passive investing strategy.

The important thing is that we patiently plough our corn into a strategic allocation of funds and don’t chase performance.

This year’s best performer is emerging markets; up 33% in 2016. Last year, emerging markets stank the house out – down over 12% – easily our worst performer of 2015.

It’s interesting to note that inflation-linked gilts are our second best performer of the year, and were second worst last year. I’m not trying to claim this is a significant pattern but I am drawing attention to the sheer futility of flinging money at the hottest funds of the moment.

Our linkers have also performed quite differently from conventional gilts over the last few months – growing over 12% versus 2%. Does the market think the latest BOE interest rate cut has likely staved off recession but heralds a greater possibility of future inflation?

Also noteworthy is that the average maturity of the bonds in our linker gilt fund is near 25 years. That’s the stuff of long-term bond funds, which means this holding is highly sensitive to interest rate rises.

Its duration is 23 and that tells us the value of the fund will fall by 23% for every 1% that market interest rates (not BOE ones) rise. The same is true in reverse – the fund will grow in value for every 1% cut in market interest rates.

Given index-linked gilt yields are well into negative territory, it’s worth considering the limited upside of the asset class versus the potential for downside.

Linkers are the best defence against unexpected inflation but short-term bond funds are a decent alternative that balance inflation protection versus interest rate risk.

About that chill

Lots of gloomy commentators in the US are preaching dark times ahead for equities as growth keeps pushing valuation measures like the Shiller P/E Ratio to dizzy heights.

Investors haven’t earned these returns they say. Growth is disconnected from the fundamentals they say.

Remember they’re talking about the US market. Most of the rest of the world looks quite cheap and even Robert Shiller – he of Shiller P/E – thinks UK equities look reasonable.

Only about 25% or so of the Slow and Steady portfolio is invested in the States. And The Investor and I were fighting running battles against DIY pundits claiming the US was overvalued four years ago. You’d have missed out on muchos return if you’d listened to the alarmists back then.

Investing 25% in the world’s global superpower is no overcommitment and I’m not in the least bit worried about it. The US market could defy predictions for years to come and I could shoot off both feet trying to dodge the wrong bullets. Should the US falter then we’re diversified enough to cope.

Still, if you feel otherwise, there are techniques to help you gently trim the sails.

New transactions

Every quarter we plunge another £880 into the market’s inky depths. Our cash is divided between our seven funds according to our asset allocation.

We use Larry Swedroe’s 5/25 rule to trigger rebalancing moves, but all’s quiet this quarter. So we’re just topping up with new money as follows:

UK equity

Vanguard FTSE UK All-Share Index Trust – OCF 0.08%
Fund identifier: GB00B3X7QG63

New purchase: £70.40
Buy 0.405 units @ £173.77

Target allocation: 8%

Developed world ex-UK equities

Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.15%
Fund identifier: GB00B59G4Q73

New purchase: £334.40
Buy 1.222 units @ £273.57

Target allocation: 38%

Global small cap equities

Vanguard Global Small-Cap Index Fund – OCF 0.38%
Fund identifier: IE00B3X1NT05

New purchase: £61.60
Buy 0.264 units @ £233.55

Target allocation: 7%

Emerging market equities

BlackRock Emerging Markets Equity Tracker Fund D – OCF 0.25%
Fund identifier: GB00B84DY642

New purchase: £88
Buy 66.768 units @ £1.32

Target allocation: 10%

Global property

BlackRock Global Property Securities Equity Tracker Fund D – OCF 0.23%
Fund identifier: GB00B5BFJG71

New purchase: £61.60
Buy 31.333 units @ £1.97

Target allocation: 7%

UK gilts

Vanguard UK Government Bond Index – OCF 0.15%
Fund identifier: IE00B1S75374

New purchase: £132
Buy 0.795 units @ £166.13

Target allocation: 15%

UK index-linked gilts

Vanguard UK Inflation-Linked Gilt Index Fund – OCF 0.15%
Fund identifier: GB00B45Q9038

New purchase: £132
Buy 0.681 units @ £193.77

Target allocation: 15%

New investment = £880

Trading cost = £0

Platform fee = 0.25% per annum.

This model portfolio is notionally held with Charles Stanley Direct. You can use that company’s monthly investment option to invest from £50 per fund. Just cancel the option after you’ve traded if you don’t want to make the same investment next month.

Take a look at our online broker table for other good platform options. Look at flat fee brokers if your portfolio is worth substantially more than £20,000.

Average portfolio OCF = 0.17%

If all this seems too much like hard work then you can buy a diversified portfolio using an all-in-one fund such as Vanguard’s LifeStrategy series.

Take it steady,
The Accumulator

Good reads from around the Web.

Back before we argued about Brexit, we used to debate whether young people were being shafted by the oldies. Perhaps in the years since you’ve become an oldie yourself?

For my part, I read articles about middle-aged men having a mid-life crisis and desperately hope the author will have thoughtlessly jotted down an age that’s somehow a couple of years older than my own. Clearly this is evidence that I actually am having a mid-life crisis, but let’s leave that for another day…

I’m still down with the kids, of course. Not only because I still have all my hair (touchwood), I’m prone to pretentious hipster-style urban foibles (discuss), nor even because my serial monogamy has left me washed up in the Tinder-era like Charlton Heston stumbling awake in The Planet of the Apes.

No, my calling card of solidarity is I never bought a property.

That’s my own stupid fault, as I’m old enough to have done better. But as I’ve said many times, it’s almost impossible to overstate what an issue it now is for 20-somethings in the South East without sufficiently wealthy and generous parents or City salaries. I still believe many older people who long ago made the leap simply don’t understand the gulf.

I was at an office recently where the Spice Girls came on the radio, and I lamented to the room in general that I remembered being in an office just like that one when I first heard the song playing some 20 years ago. (You’ve got to love the creative industries, in case you’re wondering why there’s a jukebox in every office I’m at…)

A passing Millennial shot back that she was three-years old when the song first came out, which made us all feel so ancient we could barely retort. After a few snarky comments from the others about her inexperience at life, I reminded my peers that she’d likely have 20 years after we were cold in the ground to get that fixed.

“True,” she conceded. “But at least you had the chance to buy a house.”

What a telling comment. Can you imagine a woman in her early 20s engaging in banter based around home ownership even a decade ago?

She didn’t riff on her expansive romantic possibilities, her health and youthful looks, or her freewheeling lifestyle compared to the shackled 40-somethings shambling around her.

Not sex, drugs, and rock and roll. Property ownership.

Just a little comment, but I think a revealing one.

The numbers of the beast

The good (bad) news is we don’t have to rely on anecdotes from 60-year olds about how when they first bought a house they had to sell a kidney and eat their dinner sitting on packing crates – and that yes, the three-times salary multiple on their mortgage then for a three-bedder in a nice part of town is somehow directly comparable to your ten-times salary multiple for a bedsit – because the numbers are proving the inter-generational divide is real.

Sticking with property, an article in The Telegraph this week cites LSE research that found:

Homeowners in their 40s and above who hold on to former homes and rent them out are largely to blame for Britain’s crisis in housing affordability, an academic report has found.

Research by the London School of Economics found that older people are keeping previous homes when they move on, leading to a lack of availability at the bottom of the housing market.

…which has long seemed obvious to anyone watching the market.

I do understand why this buy-to-let phenomenon happened – and I certainly don’t think landlords are individually greedy parasites or worse, as the extreme rhetoric runs – but I do think housing is a special case asset, given that there’s a fixed supply of it and that, rounding up, everyone would like to own their bit of it.

Governments should I think therefore favour owner-occupiers over cultivating a landlord class (already numbering two million as of 2014, and owning on average 2.5 rented properties each, on top of their own homes).

Happily there’s been some movement on this since I gave my own ideas on fixing the housing market in February 2015, including higher stamp duty and a change in the rules for tax relief.

But I wonder if the new chancellor Phillip Hammond will bottle it in the face of Brexit in the upcoming Autumn statement, and reverse George Osborne’s buy-to-let tax changes? Changes that were long overdue, in my view, but that are much reviled by those affected.

Fantasy land house prices are the biggest bugbear of the under-35s, but you also hear them complain about the impossibility of saving a pension. I’ve less sympathy here, given how little research the ones I’ve talked to have done into what’s possible. But new numbers from the Institute for Fiscal Studies (IFS) suggests there is some truth to this lament, too.

Indeed The Guardian reports:

The IFS said that less than 10% of private sector employees born in the early 1980s were active members of a defined benefit scheme, compared with more than 15% of those born in the 1970s and nearly 40% of those born in the 1960s.

Recent changes have seen workers automatically enrolled into defined contribution schemes, which has meant younger cohorts have higher membership of pension schemes than their predecessors, but on less generous terms.

And adding it all up, the IFS has put figures on the gap in wealth accumulation:

People in their early 30s had average net household wealth of £27,000 from equity in their homes, the value of their pensions and other financial investments.

The thinktank said that those who were born in the early 1970s had accumulated household wealth of £53,000 by similar stage.

It added that children of the 70s were themselves notably less wealthy than those born in the early 1960s.

All somewhat depressing given our society’s presumption that we should be getting richer through the generations. With higher education fees making university unaffordable even as the triple-lock makes pensioners richer, I can’t help thinking more levers need adjusting. Brexit could be the tip of the angry iceberg, otherwise.1

Of course, I’d happily trade my entire portfolio to be 20 again. So if you’re young and miserable reading all this, please remember you’re already rich.

The game is trying to stay that way, by building up your financial and other assets as time slowly takes its toll.

[continue reading…]

1. Yes, I understand you voted for Brexit for right-minded constitutional reasons. But I don’t believe the majority of the 52% did. [↩]