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Interest Rates in Europe Set to Rise Over Next Decade

Europe's demographics have helped push interest rates down in recent years, but the cost of borrowing is likely to rise as people retire later and the population grows

Stephen Ellis 3 January, 2018 | 12:12AM Allan C. Nichols

Euro banknote

As people live longer, the length of their expected retirement increases, which means their savings need to last longer. This in turn leads to increased savings

Demographics have been a major cause of the decline in interest rates in Europe in recent years: people are living longer, the population is falling, and there is increased uncertainty over pensions. Morningstar analysts expect these trends will continue and thus pressure interest rates for decades.

The European Central Bank has held interest rates at near zero for around five years to kickstart the eurozone economy, a policy that is starting to bear fruit. But further demographic changes such as later retirement, improved pension plans, higher birth rates, and more immigration, will lead to a partial recovery in interest rates in the medium term. 

ECB Will Keep Rates Low in the Short Term

The European Central Bank has been one of the latest developed world central banks to raise interest rates or unwind its quantitative easing (QE) programme, which involves the bank buying €60 billion of bonds every month.

In March 2017 the ECB said it would keep interest rates low for an "extended period"; winding down QE will be a slow process, and a tricky task for the ECB as inflation is still below target. We believe the ECB will opt for a very slow tapering process to avoid economic and market-related shocks.

It's possible that the asset purchase programme will continue at least until end of 2018 and maybe well into 2019. We also believe a slower taper will postpone interest rate increases. An orderly withdrawal from QE would minimise the odds of any economic shocks, while boosting saving rates for consumers.

Why Interest Rates Will Rise

As people live longer, the length of their expected retirement increases, which means their savings need to last longer. This in turn leads to increased savings, which puts downward pressure on interest rates as there is increased demand for savings products. This increase in demand has been pressuring interest rates for decades. While other issues have hidden this at times, such the oil crisis  in the 1970s, interest rates have been declining since the early 1980s. 

Other factors are an increased usage of technology, wage growth not keeping up with productivity growth, an increased pool of workers from the baby boomer generation, and globalisation. While many of these will likely continue to pressure interest rates, the one that will change is the labour pool, which will shrink as baby boomers retire. This should drive greater demand for the smaller labour pool, which should push up wages.

So what could drive interest rates higher in the future? 

Later retirement: Most countries are increasing the retirement age, but nowhere near as fast as life expectancies are increasing. Later retirement ages accomplish two goals at once. They increase the length of time that people contribute to pension funds or save outside of pension schemes, which allows the individual to have a larger nest egg to retire on. It also decreases the length of time a person is retired.

This means less time drawing down savings, which should enable savings to last longer. With a larger retirement nest egg and shorter time span after retirement the fear of outliving one's retirement is reduced, which allows a quicker draw down of the retirement savings, which reduces the pressure on interest rates.

Improved pension plans: Companies are increasingly moving away from defined benefit into defined contribution plans. This shift puts on the individual both the onus to manage his account and the risk of outliving savings. This effort could partially be relieved by larger company matches of savings or even auto-enrolment, as in the UK and Australia. It would also help if smaller companies offered such plans.

Having greater access to pension plans directly addresses people's fears of outliving their savings. So, again, having more savings allows people to spend more sooner, relieving the current pressure on interest rates. 

Higher birth rates and higher immigration: Most developed countries have birth rates below the roughly 2.1 needed to sustain the population as women delay having children to later in life. Medical advances will keep more people alive. While politically immigration is controversial in much of Europe, it provides a way to bring in younger people to offset the low birth rates and decrease the number of people dependent on state provision. This  reduces the pressure to save more for retirement and thus demand for savings and lower interest rates.   

Lower for Longer

However, we think some of the above demographic trends will last a long time, which will likely keep interest rates lower than they have been historically, so we expect that interest rates will rise around 0.75% over the next 10 years, and will take even longer to recover to previous levels around 5%.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Stephen Ellis  Stephen Ellis is a senior stock analyst on the Energy Team.