Did the Fed say that?!

February 20, 2019

 

Are we living in an era of low interest rates, and if so, how is that going to affect you as an investor or a retiree?

 

Hello, my name is Paul Carroll. I'm the CEO and founder of Efficient Wealth Management, a boutique wealth management first in south Texas.

 

Now fed chair, Jerome Powell, at the most recent fed meeting, had a subtle message that I think a lot of people missed, and that is interest rates, in his opinion, have reached equilibrium. You're thinking so what. Well, globally we're in an era of low rates. Inflation, generally speaking, is tamed. There are demographic challenges that I've talked about previously.

 

Today the fed funds rate is 2 1/4%. The 20-year fed bond rate is 2.9%. Inflation is just 1.6%. Real returns on risk-free bonds are less than one-half of a percent. This is a new normal according to the fed. This means, if that's the case, that any kind of returns at all require a certain level of risk.

 

Now, for most people on the bond side of their portfolio, investment grade corporate bonds will do the trick. But just how safe are these debt instruments? Since Dodd-Frank, the banks really are a lot safer than they were 10 years ago during the 2008 crisis. But there's a great deal of structural risk in non-bank lending, and there's three types of significant non-bank lending out there.

 

One is federal borrowing, the government borrowing. That's not really a structural threat. The U.S. government has printing presses, and research suggests that as long as you're borrowing in your own currency, that's not that big a deal. It may affect inflation in the future, but we don't see any signs of it at this point.

 

So we talked about government financing. The second threat is pension plans. Throughout the United States, both union, the government and large corporations, pension plans are significantly underfunded. They have expectations baked into them that just frankly aren't reasonable. Those plans are a danger, are a threat. However, the real damage is going to be significantly localized, unfortunately to the retirees that are in those plans. The secondary threat is to the states that will probably have to raise taxes to try to get these plans out from under water.

 

The third threat is with the insurance companies. There's a lot of non-bank credit at the insurance companies, a lot of non-bank debt, and that is how they are making the promises they make in a lot of their annuity products. Now, if you have a variable annuity product, at least you have underlying assets. But if you have an indexed annuity, you basically have a product where the promise is backed by the full faith and credit of the insurance company. As we know from AIT in 2008, that's not always such a great deal. So there is significant risk for people who own indexed annuities, probably a lot more significant than the insurance companies would like you to know.

 

The impact of this low interest rate regime means the risk-averse retirees are stuck between a rock and a hard place. It must feel like a conspiracy. There is, however, probably in the future going to be, as a result, a significant transfer of wealth from the young to the elderly generation. That will go for so long, at which point when the millennials start to vote, they are going to start a callback. You don't want to be at the backend of the baby boom. It probably won't end well.

 

As we build our portfolios for our clients, we are aware of this low interest rate environment. We're aware that the way to manage this is to be highly diversified in a lot of different asset classes such that we can maximize returns for a given level of risk.

 

We wish you the best of investing success. Thank you.

 

Sources:

 Foster, Sarah. “Federal Reserve Leaves Interest Rates Unchanged At January Meeting.” Bankrate, Bankrate.com, 30 Jan. 2019, www.bankrate.com/banking/federal-reserve/fomc-recap/.

 

“U.S. Department of the Treasury.” Daily Treasury Long Term Rate Data, www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=longtermrate.

 

 

 

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