The European Central Bank (ECB) has lowered its interest rates to unprecedented levels, to the point where it actually costs money for private banks to deposit money with them. The rate they now pay on deposits is negative 0.1%. And Canadian GIC investors thought they had it tough?
While Denmark and Sweden have experimented with negative interest rates, the ECB is the first major central bank to do so. Although rates in Canada have been described as “having nowhere to go but up” in recent years, Europe’s decision potentially suggests otherwise.
This is a modern day experiment in central banking to discourage banks from hoarding cash. One of the key intentions of the rate move is to encourage bank lending, which would have a resulting impact on spending, economic growth and inflation.
A further impact of the cut should be to lower the value of the euro and make EU exports more competitive, a big win for European exporters.
The European economy has really not kick-started after the 2008 recession and quite to the contrary, has experienced a ripple effect of economic setbacks.
It may come as a surprise to many investors that the Euro Stoxx 50 index is up 5.5% year-to-date and 21.6% in the past 52 weeks, after posting a 26.0% increase in 2013. It’s important to know that negative headlines don’t necessarily mean that stocks are going down, or that they are going to go down. Quite to the contrary, sometimes such events can prove positive for stock returns.
So what does this mean for Canadians? I’d say there are important lessons for borrowers (some of us) and investors (most of us).
Borrowers have got to wonder if low rates are here to stay or if they could get lower. Maybe 2.99%, 5-year fixed rate mortgages aren’t such a good deal after all? If rates are falling elsewhere, why not here?
The other side of the coin is to consider the fact that the ECB has lowered rates because they’re concerned about deflation, a decrease in prices where inflation actually goes negative. Deflation increases the real value of debt, making it harder to pay back debt when prices, incomes and asset values are declining. And given the precariously high debt levels in Canada, deflation could be particularly difficult if it ever came home to roost.
The Bank of Canada has been worried about inflation levels, but recent numbers have been quite positive.
I’d say the most important lesson for investors is that double-digit portfolio returns can’t be counted on when doing your retirement planning. Stocks have performed reasonably well in recent years, but low interest rates, low inflation and low growth are becoming increasingly prevalent within the developed world.
And while many Canadians would echo criticisms of the ECB move by Germany that low rates penalize savers, the short and potentially medium term reality of fixed income investing is a low yield.
In particular, those who are close to or into retirement need to evaluate what a sustainable withdrawal rate is from their investment portfolio to ensure they don’t outlive their savings.
Jason Heath is a fee-only certified financial planner and income tax professional for Objective Financial Partners Inc. in Toronto.
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