Declining Interest Rates And Asset Bubbles

Since the financial crisis that wiped billions of dollars off markets in 2008, capital markets around the world have enjoyed a nice run over the last decade. The stellar economic growth of both developed and emerging regions formed the backdrop for this market performance and investors were left with an abundance of opportunities to invest in, to reach their investment objectives. As the U.S. and other important economies in the world reach the mature phase in their respective business cycles, the World Bank expects economic growth to slow down considerably in the next couple of years. This, in return, will pave the way for a low-interest- rate environment, which requires investors to be extra diligent in vetting investment products.

Where are the rates headed? 

Policymakers around the world use interest rates as a monetary policy tool to keep inflation in check while providing the necessary support to economic growth. To this end, when economic growth comes to a standstill, policymakers eventually decide to cut interest rates to provide a boost to economic activities by lowering the cost of borrowing.

During the aftermath of the financial crisis, the Federal Open Market Committee (FOMC) decided to cut rates to near-zero levels, but in the latter part of 2015, the Fed decided to end its Quantitative Easing (QE) program. Starting in late 2015, the Fed decided to hike the Fed funds rate to combat rising inflation. However, the Quantitative Tightening (QT) came to an end when the Fed decided to cut the benchmark interest rate in the U.S. by 25 basis points in July, citing near-term worries for the economic growth of the country.

Fed funds rate

Even though the Fed Chair, Jerome Powell, was not dovish in the latest policy meeting, it’s apparent that this rate cut would most likely mark the beginning of a series of rate cuts to come in the future. Even though the European Central Bank decided to hold the rates steady in its last policy meeting, deteriorating economic growth prospects will prompt the ECB to take action in the future.

Rates are certainly headed for lower grounds, prompting investors to look for alternative investment vehicles to replace low-risk sovereign bonds. This phenomenon is commonly referred to as reaching for yield.

Reaching for yield 

While the idea behind cutting rates to stimulate economic activities sounds promising at first, a thorough analysis of low-interest rate environments reveals disturbing results. Historical evidence suggests that investors certainly do reach for yield when interest rates decline.

Mean allocations to risky assets when interest rates decline 

As clearly depicted in this graph, when interest rates decline, the mean allocation to risky assets increases. Further studies on this subject reveal that this phenomenon occurs when interest rates decline below historic levels, which is exactly what is happening at present. An important thing to note is that the mean excess return of risky assets in the above graph is held constant, making interest rates the only variable input.

Understandably, when investors reach for yield, the overall risk in financial markets increases dramatically, as a result of significant demand for risky assets. Investors naturally attempt to keep their investment returns at or above a pre-determined level. When interest rates are declining, it becomes impossible to achieve such pre-determined investment returns by allocating funds to government securities and other risk-free assets. The result is investors flocking to risky assets to achieve the desired investment returns, which inevitably results in assuming a higher level of overall risk to earn the same returns that were once possible when the risk-free rate was high.

Inflated asset prices eventually lead to asset bubbles and wipe billions of dollars off the table.

The growing private credit market spells trouble 

The never-ending quest for high-yield investments has given the rise to the private credit market. As historically low interest rates prevailed since the aftermath of the financial crisis, investors have shown a liking to lend to small and medium enterprises in hopes of securing better returns. The private sector, on the other hand, has grabbed this opportunity by both hands as assuming private credit is much more flexible than borrowing from a bank or any other financial institute. The private credit market is currently worth a staggering $750 billion and is expected to hit the trillion-dollar mark soon.

If economic growth slows down in the next couple of years, as expected by the World Bank, small and medium enterprises will find it difficult to honor their debt payment obligations, which could give birth to the next economic recession. However, investors are seemingly unaware of this risk and are focused on securing better returns in the short-term as opposed to identifying and mitigating the risks involved in lending for private borrowers.

Low rates supporting all-time highs in equity markets 

Equity market investors embrace decisions by regulatory authorities to cut rates as economic theory suggests that interest rates and equity prices are negatively correlated. However, persistently low rates and the stellar global economic growth over the last decade have already pumped up equity prices to never-before-seen highs.

Low interest rates have left investors with no other option but to invest in risky securities.

The Shiller PE ratio, the inflation-adjusted price-to-earnings ratio of the S&P 500 Index, is already above the range it was prior to the devastating events of Black Tuesday and Black Monday, and well above the range it traded just before the financial crisis a decade ago.

The Shiller PE ratio 

Even though the Shiller PE ratio is issuing warning signals to investors, there’s no sign of investors backing away from equity securities at present. As a result, it would only be normal to see the ratio expand even further, leading equity prices to inflate beyond sustainable levels. The risk of an asset bubble is very real and the hype related to investing in stocks at these levels is a clear warning sign for prudent investors. 
This is not to claim that there are no attractive investment opportunities in equity markets. There are and there will always be. However, when the bubble bursts and broad markets enter a bear run, undervalued securities will further deviate from their intrinsic values before staging a comeback.

Conclusion 

Historical evidence suggests that low interest rates lead to asset bubbles and that investors take excessive risks to achieve desired investment returns, exposing their portfolios to a higher overall risk. Stock prices are already inflated and the rise of the private credit market spells of trouble ahead. A decade ago, the housing market bubble that formed under low interest rates lead to a bloodbath in markets. Continued risk-taking could lead to an asset bubble, which would wipe billions of dollars of investments off the table when burst.

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