Focus

August 30, 2019 | 13:03

Five Real-World Impacts of Plunging Interest Rates

Economist

Director and Senior Economist
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Michael Gregory , CFA

Managing Director, Deputy Chief Economist and Head of U.S. Economics
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Sal Guatieri

Director and Senior Economist
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Robert Kavcic

Director and Senior Economist
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Michael Gregory , CFA

Managing Director, Deputy Chief Economist and Head of U.S. Economics
Economics

Michael Gregory is Deputy Chief Economist and Head of U.S. Economics for BMO Capital Markets. He manages the tea... (Read more)

Benjamin Reitzes

Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Sal Guatieri

Director and Senior Economist
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Feature

From Bay Street to Main Street: Five Real-World Impacts of Plunging Interest Rates

Financial markets are digesting a heavy dose of uncertainty surrounding trade developments, monetary policy and late-cycle economic conditions. Arguably the most dramatic impact has been the plunge in long-term interest rates around the world, and Canada has been no exception. Indeed, 10-year GoC yields are now below 1.2%, while 30-year yields are more than 60 bps below the Bank of Canada’s 2% inflation target, hitting a record low 1.3% earlier in the month. This reflects many factors, both cyclical and secular, such as a flight-to-safety given elevated recession risk, lower inflation expectations and a longer-term downward pull from demographics. Here are five important ways this will matter for Canadians beyond the trading desks:

Homebuyers. The plunge in bond yields has already pulled down five-year fixed mortgage rates in a big way, with that term now readily available for around 2.5%, or almost 100 bps lower than in late-2018 (Chart 1). For someone shopping at the $750k level with 20% down, that’s either $70k more buying power or $300 per month in extra disposable income. Also, Canadians who took out a five-year fixed mortgage four or five years ago, and were recently threatened by the prospect of having to reset into meaningfully higher interest rates, no longer have to worry. And, remember the old cliché that we need to prepare for when mortgage rates ‘go back to normal’? Well, we might have already seen that. Similar to lower potential growth and lower neutral interest rates, if 5.5% was ‘normal’ for a five-year fixed mortgage late in the cycle in 2006, maybe 3.5%-to-4% is the late-cycle norm today—coincidentally, we just pulled back from that level.

Takeaway: Mortgage rates continue to surprise to the downside despite persistent warnings of ‘going back to normal’, because ‘normal’ today is much lower than in the past.

Businesses. As borrowing costs have fallen, firms have taken the opportunity to lever up. But, business investment has remained soggy. Small- and medium-sized businesses might still be coming to terms with the reality that investment hurdle rates (or cap rates) need to be lower than in the past. Commercial cap rates are a good example of this. In the decade leading up to the financial crisis, industrial space in the GTA was yielding roughly 8% on average; since then, that rate has fallen to about 6%. More broadly, commercial cap rates (including the much-discussed residential sector) have fallen persistently and sharply in recent years. But what’s most interesting is that the spread relative to risk-free bond yields has remained constant, and is in fact right in-line with the 10-year average today (Chart 2).

Takeaway: Business decision makers or real estate investors, who have used a certain hurdle rate to invest, need to bring that rate down today.

Investors. Portfolios of many different shapes have had a great run given the extended bull market in stocks and the bond portfolio capital gains that come with falling interest rates. Ignoring the fact that we are later in the cycle, which comes with its own set of strategic considerations, bigger-picture fundamentals argue for lower longer-term investment returns. Consider a rearranged dividend discount model for valuing stocks, which shows the equity risk premium currently at roughly 4% in the U.S., and a touch higher in Canada. Given assumptions for growth, inflation and the risk-free rate, it would yield equity returns in the 6%-to-7.5% range. Note that real growth in Table 1 is based on our estimate of potential economic growth, and real dividend growth could run stronger. This is especially true in the U.S., where the index has more weight in faster-growing sectors, and more exposure to faster-growing global markets. Meantime, if bond yields continue to trend around the lower end of their post-financial crisis range, it would indeed keep balanced portfolio returns well below what many have been used to historically, likely in the 4.5%-to-5.5% range.

Takeaway: Cyclical considerations aside, it might be prudent to ratchet down long-term portfolio return expectations.

Retirees and Savers. If long-term return expectations are lower for planning purposes going forward, then Canadians can respond in two basic ways: save more of every dollar earned, or work longer. The trouble is, when interest rates are so low, the incentive to save is reduced. Indeed, Canada’s household savings rate has averaged barely above 1% over the past four quarters, a record low. The flip side is that Canadians are indeed working longer, with participation in the 65+ age group now sitting at 15%, or more than twice what it was a decade ago (Chart 3). Put another way, there are now almost 600k more Canadian seniors in the labour force than there would otherwise be had participation not already risen.

Takeaway: Save more, or work longer. Right now, Canadians are opting for the latter.

Governments. Arguably some of the biggest winners from lower interest rates are the federal and provincial governments, most of which continue to run deficits, borrow for capital spending purposes and/or face chunky refinancing requirements in the coming years. Consider that Ottawa’s 2019 budget assumed a 10-year yield of 2.4% and 2.7% in 2019 and 2020, respectively, and roughly two Bank of Canada rate hikes. If longer-term yields stay where they are today and the BoC cuts rates once, Ottawa could be looking at nearly $2 billion of fiscal upside, all else equal. This will extend the windfall governments have received throughout much of the past decade (Chart 4). Meantime, governments can now readily borrow long term for at or below the rate of inflation, a boon for infrastructure-hungry provinces.

Takeaway: Less money for debt service means more available for programs and/or tax relief. Government priorities will vary.