Money Gets More Expensive

Edited Photo. Source: Flickr - Jayne & D

Last week Wednesday the Bank of Canada governor Stephen Poloz raised the overnight bank rate another 0.25% to a new target rate of 1%. The overnight target rate is the interest rate set for inter-bank lending in Canada.

Of course none of us this ever see this still-absurdly low rate. We always pay a premium of ~2%. But every change of the overnight rate impacts how much loaned money costs us as consumers of debt and how much money pours into the economy.

Dumbing Down Central Banks

To understand the importance of the overnight rate changes, it's worth knowing basic central banking for dummies.

The central bank – the Bank of Canada here, or Federal Reserve in the U.S.A. – is a quasi-government institution that controls the country's money and thereby the economy. While the Bank of Canada is an arms-length Crown corporation, the Federal Reserve is a private institution owned by its member banks who provide the capital and managed by Congress and those member banks.

The Federal Reserve, actually made up of 12 individual Federal Reserve Banks, can almost be thought of as a sort of credit union for the nation's banks. Each member bank – by law all federal chartered banks operating in the U.S. ranging from Citibank to Bank of America to Banco Santander to the Cornhusker Bank – provides a specified amount of capital to it's Federal Reserve Bank. The Fed Bank than provides banking services to its member banks including account maintenance, transactions, loans, deposits, etc.

All profits generated by the Bank of Canada go the Ministry of Finance who technically owns the bank's shares. The profits of the Federal Reserve system are shared; a flat 6% dividend is paid on each member bank's capital contribution while the rest of the profits (about $100 Billion last year) goes to the U.S. Department of Treasury.

Despite their unique structure, both banks largely operate the same way and have the same goals. They are the bank for banks; they set the inter-bank interest rates; they control inflation rates; and they attempt to set the value for the nation's currency.

Most of the goals are accomplished with one simple tool: setting the inter-bank lending rate. When the bank lending rate target is lowered, it increases the demand for money as money is cheaper to borrow. When the rate is increased, the demand for money drops as money becomes more expensive. This in turn controls inflation and increases the value of currency.

The country's banks generally earn a 2% spread on the inter-bank rate. This is where banks make their money! Inter-bank rates set rates for GICs and savings accounts as well. This is because a bank can obtain their funds either way. They can take a deposit from you, or they can obtain a loan from another bank.

If you put your money in a GIC at 1% interest and the bank gives you a mortgage at 3% interest, you are basically giving your bank a license to make money from you.

Cheap Money Economies

We know when money becomes cheaper, demand for money increases. This means more money floods into the economy. As a result, demand for goods increases and this drives prices up.

People have a tendency to spend as much as they possibly can, pushing the spending limits of their income. Meanwhile banks are also incentivized to loan out as much money as they can to increase their assets and profits – as long as the loans and interest get paid and customers don't push the limits too far and become insolvent.

Many academics and large investors have suggested the world – particularly the developed west – is currently in an asset bubble. Following the Financial Crisis of 2008-2010, interest rates have been set and maintained at historic lows by the central banks.

A lot of this cheap money was used by banks and investment managers to buy financial assets as they are very liquid: government bonds, corporate bonds, and stocks. This has made bonds and stocks expensive compared to their normal ranges of valuation.

It has also encouraged consumers to buy hard assets with debt: houses and vehicles in particular. Household debt is extremely high in many western countries while savings rates are extremely low. And the banks will keep lending as long as payments are made. Payments will be made as long as unemployment stays at these very low levels.

However, this won't continue forever. Economies work in cycles. They always have they always will. There are no "new normals". At some point in the future, economic growth will stall when borrowers hit their limits. Employment rates will drop as businesses cut staff to maintain profits. Unemployed people will default on their loans. And, in response, banks will tighten their lending standards and clean up their balance sheets.

In the past, central banks helped speed this painful process up by quickly reducing inter-bank lending rates to help people make their payments and inject money into the economy. But when rates are already low, how much can rates be cut?

I suspect very difficult decisions will have to be made and the next deleveraging cycle will be very painful. John Hussman, a fund manager and very vocal critic of current interest rate policy, expects we will see the S&P 500 valued at just 1000 in the coming years. That implies a 60%+ drop from current levels.

His valuation models, somewhat based on Shiller CAPE (he uses several unique models), suggest an investor using buy-and-hold strategies today on U.S. stocks may have an expected 12-year return of -2%. That's a lower expected return than the 1929 and 2000 market bubbles.

I'm not a buy-and-hold investor, and I don't care much about valuation predictions about financial markets, but I think it sheds some light on just how far we've pushed the limits of credit and asset valuations in our economic environment.

Debt Management

Just because cheap money has caused structural problems in the larger economy and tempted you to buy more house or car than you need, there is a way to insulate yourself from that cruel teacher known as economic cycles.

Every time interest rates are ratcheted up to tame debt growth, spending is curtailed just a little bit. This adds up over time and eventually the market corrects, bringing an end to one economic cycle and starting another one.

In your personal financial world you can choose not to let economic cycles tear your finances apart. No consumer debt, a very manageable mortgage, and a healthy investment account are obvious wise decisions.

No consumer debt is important as it often carries higher interest rates or hidden interest costs. Vehicle loans, credit cards, lines of credit, and personal loans should be avoided at all costs and paid off ASAP if emergency circumstances make them unavoidable. This includes HELOCs used for consumer purchases, home maintenance costs, or home improvements.

Your mortgage costs should be less than 20% of your household gross income. Pay down your mortgage aggressively to get to this point by your next renewal! If it's impossible to achieve in the foreseeable future, you should downsize or rent.

The only way to build a healthy investment account cushion is through difficult, dedicated, determined, regular saving. Then, you have to invest those savings to put that money to work for you. Simple options are out there. A lazy portfolio like the RM Balanced Portfolio or the Canadian Couch Potato is one choice. You can also follow a Dual Momentum strategy which is just as easy and reduces drawdowns.

Trend investing is another option, but probably not a good choice for 98% of people out there who let their emotions get in the way.

Just knowing that you have $25,000 or $70,000 or $400,000 tucked away (age dependent) and growing for you is a huge stress mitigator.

Interest rates are going up – there's no doubt about that. Prepare yourself as the end of this cycle creeps closer.

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