The dark side of low interest rates

There is a cost to low interest rates. Just ask savers pondering the merits of the Royal Bank’s so called “high interest” e-savings account, a typical offering in Canada. The rate: 1.2 per cent. For U.S. dollar savings, the return is positively microscopic, only 0.25 per cent.

As markets await the results of Thursday’s policy-setting meeting from the U.S. Federal Reserve Board, more easing of interest rates is the widely expected outcome. But it’s also clear that low interest rates don’t come cheap.

While low rates are a boon to borrowers, they inflict pain on others. Anyone who hews to the old-fashioned virtue of saving is an obvious loser. So are pension funds, money-market funds, shareholders in life insurance companies, and even banks themselves.

“Like any other action, there is going to be winners and losers” from the Fed’s low interest-rate policy, says David Rosenberg, economist at Gluskin Sheff and Associates, the boutique Toronto-based money manager. “The Fed is deliberately penalizing those savers who are so risk averse that they’re willing to keep their money either in treasury bills or in bank deposits.”

Mr. Rosenberg said low rates amount to “a subsidy to borrowers at the expense of savers.”

To be sure, many investors see upside for the stock market based on the prospect of low interest interest-rates. 

The betting on the Street is that the Fed will undertake some kind of quantitative easing, another name for money printing, at this meeting, which will keep interest rates low. It may also give guidance that it foresees keeping rates at extremely low levels into late 2015, rather than 2014, as is now the case.

Hopes for more monetary stimulus have propelled stocks higher, with major indexes in New York and Toronto gaining about two percentage points over the past five days. If the Fed acts, as expected, the immediate reaction in financial markets will likely be more exuberance. But investors should be on guard: Low interest rates aren’t an unalloyed blessing.

In a recent note to clients, Eric Sprott, the head of Sprott Asset Management, raised questions on “how well the financial system can cope in a relentless low-to-no-yield environment for bonds.” The last four years of low rates “have already wreaked much damage” on industries that depend on a wide spread between short- and longer-term rates, he said.

Mr. Sprott singled out life insurance companies and banks as particularly sensitive to low rates.

Banks make money on the difference between what they pay depositors and what they earn on loans, known as the net-interest margin.

Low rates cause margins to compress, even though savers are getting paid next to nothing on deposits.

Bank margins were at 4.5 per cent back in 2007, when five-year government of Canada bonds were yielding around 4.2 per cent. Currently, the bonds yield about 1.5 per cent, while average net interest margins at the bank were 2.55 per cent in the second quarter, according to figures compiled by Mr. Sprott.

“There is a range of interest rate levels that are comfortable for the lifecos and for the banks, and that’s above the levels were they are now,” observes Michael Goldberg, financial service analyst at Desjardins Securities Inc.

Life insurance companies are harmed by low rates because they need high income from their investments to pay future obligations to policy holders and those receiving annuities. If rates are too low, profits suffer.

Pension plans are similarly affected. Based on figures from Mercer Canada, Mr. Sprott said the solvency position of defined benefit pension funds in Canada is at an all-time low.

Pension fund managers typically make assumptions that they can meet their obligations to retirees by earning returns on assets averaging 7 per cent or 8 per cent a year. That’s hard to do when 10-year government of Canada bonds yield less than 2 per cent. “Right now, pension funds are in an awful position,” Mr. Goldberg says.