The announcement by the Bank of Canada that it is holding its key policy interest rate (also referred to as the "target for the overnight rate”) at 1% for a protracted period of time confirmed what many people already thought to be true – the global economy, including the Canadian economy, is still struggling to recover from the economic contraction of 2008-2009 and the odds of a double dip have increased.
What does this mean for financial advisors and their clients? First, the struggle to find positive rates of return continues. For the risk adverse client used to buying GICs and T Bills, the news is dismal indeed. Today's low interest rates are likely here to stay for at least another year, maybe more. This is creating a real strain for many seniors who don't want to dip into their capital but who are being forced to because of the extremely low yields available in the market.
From a planning perspective, it also throws into question the correct assumptions about an appropriate real rate of return to use on a go forward basis. The lower the real rate of return, the more money people have to save to ensure they have sufficient capital prior to retirement. For example, if a retiree wants $5,000 a month of actual purchasing power for a 25 year retirement and real rates are expected to be 5%, they need to have saved $855,000 as of their retirement date (assuming they will exhaust their capital at the end of the 25 year period). However, if real rates are only 2%, they need almost $1,200,000 of savings. And with today's real rates hovering around 1%, they would need about $1,327,000 of savings.
Unfortunately, the problem doesn't end there. High real rates prior to retirement make the process of saving for retirement easier. With today's extremely low rates, much more of the heavy lifting has to come from actual savings and much less can be expected to come from compounding within the portfolio.
As if this were not enough, the final problem is the rapid rate at which Canadians are piling up debt. Induced to take on more debt by today's extremely low interest rates, the average individual in Canada has debt equal to 146% of disposal income, which is approximately equal to the debt carried by US citizens prior to the meltdown of 2008/2009.
However, whereas the US consumer has rediscovered the virtues of thrift and the value of saving money, Canadians are continuing to add to their debt loads at a rapid pace. When interest rates eventually start to normalize, the increased burden of carrying this debt will reduce their ability to spend on other goods and services, potentially putting a drag on Canadian growth rates for several years in the future.
QE2 To The Rescue - Keeping Assets Afloat
The Federal Reserve announced at its most recent meeting that it stands ready to unleash even more money (money printed out of thin air, thereby called Quantitative Easing) in the bond market if the economy slows. This sets up yet another bizzaro universe scenario where any and all news only drives the equity markets, commodities, and precious metals higher, as good news is seen as, well, good, and bad news is seen as further reason for the Fed to act.
As long as new liquidity flows into the market, there is the continued devaluation of all dollars already in the system, thereby leading to the increased prices for metals, other commodities, and equities.
Make no mistake, the Federal Reserve is redrawing the economic pie when it prints new dollars. Their share gets bigger, all outstanding dollars get smaller. Every single dollar in your pocket is worth less.
So what’s the goal? What could possibly be of such importance that it makes theft by the government an appropriate course of action? Your well being, of course.
The government has clearly outlined a strategy that is intended to save all of us from…pain. Financial pain, to be more precise. To save us from falling home values, equity values, incomes, etc., the government has embarked on a massive program to prop up all valuations. But the government cannot do this on its own, as it has no funds. In order to do this the government must get the economic horsepower from somewhere. The US government in the form of the Treasury Dept could borrow the money, but that would require messy Congressional approval for a number that is over 3 times the size of the stimulus package. Instead, the Treasury relies on the Federal Reserve to do the heavy lifting, purchasing $1.7 trillion in assets so far, with another round of purchases estimated to by right around the corner. If the new round fo QE comes in at the estimated $500 billion , then a full $2.2 trillion will have been printed out of thin air to prop up the rickety assets in the US.
Where does the economic force behind these new dollars come from? From savers, of course. Every one who has a US greenback to their name pays the price. Each dollar gets nicked, so the more dollars you have, the more you get nicked.
What happens when it doesn’t work? What happens when the Fed has printed $2 trillion plus and the jobs market does not pick up? Companies don’t rush out to advertise in the help wanted section? Individuals don’t charge up their credit cards or take on new loans?
We are already here. The Fed has spent approximately $1.7 trillion, and that’s on top of the US government’s $700-800 billion stimulus, and unemployment is still hanging right about 10%. Credit outstanding in the US is still falling. The overwhelming weight of deflation is still pressing on the markets.
At some point, this disconnect between the Fed’s stated goals and the reality of the economy will have to be recognized. Then the pain that the Fed was trying to avoid will descend on us anyway. Except, we will have squandered some of our purchasing power ahead of time, making the situation even worse than it would have been.