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Expat Investing in a Low Interest Rate World

by Expat Focus investment partner, Tom Zachystal

On August 9th Ben Bernanke, Chairman of the US Federal Reserve, made an unprecedented announcement (I guess by now we should be used to unprecedented announcements from the Fed). He announced that the Fed would keep US target interest rates low for two years. Never before has the Fed committed to a time-span for its interest rate policy.

Many investors were disappointed that the Fed didn’t announce a further economic stimulus measure but in fact the actual announcement is much more useful because it helps bring certainty to what has become a very uncertain investment market.If interest rates are to remain low, this creates less competition for fixed income type investments. Bond prices go down as interest rates go up and one of the great uncertainties in the bond market during this extended low-interest rate period in which we have been living has been when to get out of bonds, as surely interest rates must rise at some point. Indeed a few months ago I wrote in this space about my concerns regarding fixed-income investments. Now we know that interest rates won’t rise for a while but this is not to say there are no concerns about low-yielding bonds. A concern that remains is that this low-interest environment may spur inflation and if inflation is running at, say 4%, then investors wouldn’t want to be locked into low-yielding bonds.

Low interest rates also create less competition for investments that do not pay an income; commodities for example – especially commodities such as gold that do not trade solely on supply/demand fundamentals. If we could get a decent yield in a savings account then we might be less inclined to put our money into something that is more difficult to value and does not give us a cash flow – we might put our money in the bank rather than holding gold.

Low interest rates also mean low mortgage rates – which can help support property values. To the extent that short-term interest rates are significantly lower than longer term rates this should also be good news for mortgage lenders such as banks, that make their money partially on the spread between mortgage rates and short-term rates.

What about the stock market? Low interest rates should encourage stock market investment amongst people who would rather take some risk than leave their money in a low-interest-paying bank account. Conservative equity investors might buy dividend-paying stocks that offer higher current yields than 10-year bonds.

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So it seems that continued low interest rates are good for almost any type of investment – surely the picture cannot be so rosy. Indeed it isn’t; there is no free lunch and there are four risks that I see from this policy.

The first risk is inflation: Keeping rates low risks inflationary pressures as money becomes cheap to borrow leading to a borrowing binge and inflationary spiral. General inflation in the developed world does not seem to be an issue at the moment, as companies remain cautious about investment and unemployment remains elevated. However, in the emerging world, especially amongst countries that peg their currency to the US Dollar and thus import US monetary policy, there is a real risk of inflation. That being the case we might expect more commodity inflation than wage or real estate inflation in developed markets. Also, to the extent that this policy is negative for the US Dollar, a decreasing USD would cause import prices to rise in the US.

The second risk is a declining US Dollar: Investors may choose to park their money in higher-yielding currencies. Of course other issues also affect the currency markets – for example, loss of confidence in the European banking system would probably be more negative for the Euro than any gain from a higher interest rate. Still, near-term it may be worth looking at companies that derive a substantial amount of income from non-US markets. Longer term, if the US Dollar significantly weakens, this would not be good for companies that manufacture outside the US and export to the US, as their costs could rise faster than their revenues.

The third risk is a near-term loss of confidence amongst investors: A low interest rate policy from the Fed implies that the policy-makers envision risks to US growth and employment. The Fed has a dual mandate to maximize employment while maintaining stable prices. Clearly the Fed at the moment sees a greater risk to employment than inflation. In such an environment investors may well conclude that a low-growth period is ahead and could flee US investments in general.

The fourth risk is that of forming bubbles: The Fed’s low interest rate policy in the early 2000’s helped to create the real estate bubble that ultimately burst in 2008. We may well see bubbles develop in popular markets today. By “popular” I mean commodities, especially gold, and real estate in certain emerging markets, as well as bonds. Still, bubbles usually take a long time to form.

So what has actually happened since the Fed’s announcement last week? Treasury bond prices have gone up, especially inflation-indexed bonds, gold has continued its ascent, stock markets have been volatile but currently are down, with dividend-paying stocks holding up better than the broad market (comparing the iShares High-Dividend Equity Fund to the S&P500 index), and the US Dollar has been largely flat against its trading partners. It has only been ten days since the Fed’s announcement but so far, except for the stock market (which is more driven by European sovereign debt issues these days), things seem to be going mostly as expected.

This article is for informational purposes only, it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.

Read Tom’s previous columns

Individual Asset Management is a U.S. Registered Investment Advisor; Tom Zachystal is a Chartered Financial Analyst, and Certified Financial Planner™ professional with over ten years expatriate portfolio management and financial planning experience. He has clients on four continents in over a dozen countries and is one of the original members of the Expat Focus Trusted Partner Network, a small group of financial advisors selected specifically for their professionalism and integrity. His services include: US or offshore investment accounts, IRAs, 401ks, portfolio/investment management, UK SIPPs, UK pension transfer to the US or elsewhere (QROPS), retirement planning and other financial planning services for US citizens living abroad or residents of any nationality living in the US.

Click here to send Tom a no-obligation enquiry for financial advice.

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