Interest rates: Lower for longer

For quite some time, we have all been wondering when interest rates in the U.S. will begin the process of normalization. For the past several years, forecasters have predicted that rates will rise within months, only to be proven wrong as rates stubbornly stayed where they were. Seven years after rates were cut to near zero, we remain in a holding pattern of extremely low rates, and it is hard to see when things will change. There are two schools of thought for what will happen in the near future regarding the global market and economic environment. On one hand, some predict that we will have a normal cyclical recovery that will bring about a rise in interest rates. In this scenario, real gross domestic product will grow at or above trend levels. Wages will increase as unemployment falls and inflation will also rise, setting the global economy on a new path to growth. On the other hand, there are those who believe that interest rates will stay at historically low levels for a longer period of time, due to deteriorating demographics, low productivity growth and a need for more deleveraging. We take the latter point of view. Several obstacles stand in the way of a resurgence in economic growth. One is a shrinking labor force which, combined with stagnant productivity growth, will have an adverse effect on GDP growth. Excess leverage is also a concern as both governments and corporations worldwide have taken on massive amounts of debt over the past several years. Steps toward deleveraging have not been taken, which could hinder wealth creation. Other, not-so-obvious dynamics also are keeping rates at historic lows. Pension plan sponsors are actively trying to manage risk in their portfolios by turning to liability-driven investing strategies. Since such strategies involve matching the maturities of fixed-income investments to the duration of plan liabilities, demand is increasing for fixed-income securities. As demand rises, so do prices. Yields move inversely to prices, and therefore they fall and interest rates stay low. Demographics are another factor keeping the demand for fixed income high. This is because investors typically choose to invest a greater portion of their portfolios in fixed income as they age. A higher percentage of fixed income will usually reduce portfolio volatility, which is important for someone who has retired and must now begin drawing down what they've saved in order to live on these funds. Again, demand for fixed income results in higher prices and lower rates. Finally, inflation remains low or nonexistent, which also makes it less likely that rates will rise. In the past year, commodity prices have dropped dramatically, which put less pressure on inflation. Without much of an increase in inflation, there is little reason for central banks to raise interest rates. So lower for longer is our stance at this time. Although there is a lot of speculation surrounding when and if rates will begin to rise, there are plenty of reasons to believe rates will stay low for the near future — and not many reasons for things to change anytime soon. Charles Tan is head of North American fixed income at Aberdeen Asset Management.