Interest Rates and the Black Death

September 19th, 2016

For the last 18 months, I have been volunteering with the Financial Planning Standards Council on the awkwardly-named Projection Assumption Guidelines Committee.

This committee publishes, annually, projected rates of return for fixed income, equities and other investments. These projections are guidelines for financial planners building models that demonstrate clients’ financial situation for the next 25 to 30 years.

The FPSC published such Guidelines for the first time in 2015 and the feedback was overwhelmingly negative. “Your rates of return on a balanced portfolio are too low. How can I possibly tell my clients that the best rate of return I can get them is 3.30% (after expenses)?”

When the FPSC published the Guidelines for the second time in 2016, the feedback was similarly negative. “Fixed income returns of 4%? Thirty-year Government of Canada bonds are currently yielding 1.65%. How long is it going to take you to admit you are wrong?”

Because I have a professional interest in understanding where interest rates are going, an article in the July 23rd Economist magazine got my full attention.

According to the Economist, “the world is about to experience something not seen since the Black Death in the 14th century – lots of countries with shrinking populations. Already, there are around 25 countries with falling headcounts; by the last quarter of this century, projections by the United Nations suggest there may be more than 100.”

Their argument is that interest rates will stay low in the future based on the relative sizes of two different groups of people.

The first group are the borrowers, younger people entering the workforce and buying houses which they finance with mortgages. The second group are older people saving for retirement and ultimately leaving the workforce with significant savings. This group will be called the loaners.

In general, in the seventies, eighties and nineties, the number of borrowers rose. This was driven by the entry of women in the work force magnified by the arrival of the boomers.

This generation created a huge and growing market for things like houses and cars, financed with borrowed money.

Population projections now show that over the next few decades, the number of borrowers is going to shrink. This is being driven by the boomers retiring, magnified by the fact that birth rates have dramatically declined.

In the seventies to nineties, the growing number of borrowers increased the demand for loans. During the same time period, the number of loaners was small and the supply of funds available for lending was limited. Simple Economics 101: increasing demand + limited supply = prices (interest rates) increase.

Starting around the turn of this century, the numbers of borrowers leveled off and then started to drop, with the result that demand for loans began to fall. At the sane time, the number of boomers saving for retirement (aka lenders) grew dramatically, increasing the supply of money to fund loans. Simple Economics 102: falling demand + increasing supply = prices (interest rates) drop.

This is a very simple description of a very complex issue. Yogi Berra was right. “It’s tough to make predictions, especially about the future.”