Whenever you request guidance on how to invest to reach FIRE, you will often receive the comment you should invest in Emerging Markets e.g. through IWDA + EMIM. But should you?
Last Updated on September 6, 2019 by Mr. FightToFIRE
You’ve probably heard this word a few times in the news already, especially in lieu of the financial crisis and later the euro crisis. It probably also came up recently because it went below zero in your country as it did in mine not too long ago. I’m of course talking about long-term interest rate and their low (even negative) level.
So, what’s up with that? Why is this news? I’ll get to that in a minute but first I want to make sure we all know what we are talking about here and for that, you first need to know what bonds are.
In simplest terms, a bond is an I.O.U. between a lender and a borrower that includes the details of the loan and its payments (amount paid, interest due, end date, etc.). Companies and even governments issue these bonds to get fresh cash.
It are these government bonds that determine the long-term interest rate. Just like any other bond, government bonds expire at a certain date. This is called maturing and it are the government bonds that mature in ten years that set the long-term interest rate. The rate itself is set by taking the average rate every day of all the bonds that end in ten years.
Now we know what the long-term interest rate is, but why is it so low? To answer that question we have to look towards the ECB, European Central Bank. It basically exists to maintain price stability within the Eurozone. To achieve that in the current unstable times, their current monetary policy is to lend money free of charge to commercial banks and also to buy bonds. As a result, a lot of money comes into circulation, for which a destination is being sought: the government bond.
Though the ECB isn’t doing those things just because. It’s in part due to the exchange rate change of the Federal Reserve, the national bank of the US. They no longer look at an interest rate rise like it did the last couple of years when the US was clearly doing great but they are now looking into a decline.
On top of that are the current economic problems for world trade, with a lot of uncertainties, for example, due to trade disputes between the US and China.
Moreover, in that context, the European inflation outlook remains low, which has also prompted the ECB policymakers to tread carefully.
The long-term interest rate has an Impact on you
It’s clear the unusual situation is the result of the European Central Bank’s policy. We answered what, and why, now lets take a look at arguably the most import thing, how this impacts you and me. It has a distinct positive and negative impact on everyday life. Negative for the (conservative) savers, but positive for those that are looking to borrow (long term).
As a saver
This low interest rate is not so good if you are a saver. The savings rate is based on this long-term interest rate, so if it’s low, banks will keep their savings rates low as well. Luckily (for the saver) in Belgium the interest rate has a minimum of 0.01 percent and a fidelity premium of 0.10 percent. The basic interest rate applies to every day that an amount is in the account, the fidelity premium is added to that for funds that are retained for one year.
As a borrower
Conversely, this has a positive impact on you if you want to borrow. Residential loans with a fixed interest rate of 20 years at a rate of less than 1.30 percent are no longer an exception. Anyone who borrows in a shorter period of time may be even cheaper off. Despite reports that housing loans are too cheap, banks remain willing to do business at these low rates.
As a side note, the low-interest rate is also good news for the taxpayer. Because of the very low or even negative position, the government can borrow very cheaply or even make money by taking out loans. In a country with a very high national debt, this has been taken into account.
Due to the impact these long-term interest rates have, it’s not surprising that institutes such as the OECD and ECB try to make forecasts. Since a forecast is literally trying to predict the future, which to my albeit limited knowledge of the universe, nobody can do, you got to wonder, how accurate are they and thus how useful?
According to their latest 2020 estimate, the EU should see an average long-term interest rate of 1%. Whether this will be reached is impossible to say. They do intensive research on the subject before they publish these numbers so it’s a good guestimate.
Interestingly enough and to my surprise, these estimations are fairly accurate as of late (Baghestani, 2019) so that 1% is going to be pretty spot on. Though in the past this was less so (Kolb & Stekler, 1996) and they were barely any better than random walk forecasts. What is a random walk? A random walk isn’t just a list of random numbers. The next value in the sequence (like the forecast of the long-term interest rate) is a modification of the previous value in the sequence.
- OECD, Retrieved from https://data.oecd.org/interest/long-term-interest-rates.htm
- A. Kolb, R & Stekler, Herman. (1996). How well do analysts forecast interest rates?. Journal of Forecasting. 15. 385 – 394. DOI: 10.1002/(SICI)1099-131X(199609)15:5<385::AID-FOR627>3.0.CO;2-B. Retrieved from https://www.researchgate.net/publication/229945147_How_well_do_analysts_forecast_interest_rates
- 2019. Long-term interest rate predictability: Exploring the usefulness of survey forecasts of growth and inflation. Cogent Economics & Finance, 7:1, 1-12, https://www.tandfonline.com/doi/full/10.1080/23322039.2019.1582317