Easy monetary policy from global central banks has done a lot to help the global economy grow after the downturn of the Great Recession. Although the economy has continued to grow, it is not without consequence. This grand experiment that central banks have done is exactly that, an experiment. No one really knows what the consequences will be with such a policy, and no one really knows when it is time to stop the experiment.
The monetary policy is simple to understand; keep interest rates low, and liquidity high. Interest rates are a tool that central banks have to either help boost an economy or slow it down. Typically, central banks will lower interest rates to help spur economic activity, while they raise them to slow it down.
In theory, lowering rates should help spur economic development because it makes it easier for people and companies to borrow money. They then use this cash for economic activity. Vice versa, if interest rates are raised, it makes borrowing costlier and thus slows down economic activity. Since the Great Recession was so drastic and harmful to the economy, interest rates were brought down to extremely low levels and for an extended period of time.
Not only were interest rates lowered to unprecedented levels, quantitative easing was used to increase the money supply. Quantitative easing was another response to the damaged economy from the Great Recession. In order to decrease interest rates in bond markets, central banks began to purchase large quantities of bonds through the open market. This in turn lowered rates along the yield curve, and increased the money supply. With more money in the system, it increases the supply and lowers the cost of borrowing. This in turn should increase the demand for cash, using simple supply-and-demand theory.
Now, all of this easing is bound to cause market reactions. For one, there is artificial demand created by central banks in the bond market. There is also a massive amount of liquidity in the market because of the large amount of money supply. And lastly, suppressing interest rates for such an extended amount of time can also pose a problem.
Artificial Demand for Bonds
Artificial demand for bonds means that the prices for bonds have raised, and investors have gained from it. With the central banks around the world inflating the asset, they are also drawing more demand for the asset because they know the central banks are helping the returns. It is like having insurance on your investments. In the beginning the Federal Reserve was basically guaranteeing that rates would go down, and your investment would rise in value. All of this demand for bonds pushed prices up, and made them more expensive.
This has also helped raise the prices of stocks that have higher dividend yields, and stocks that are linked to interest rates. For example, demand for utility stocks have grown and pushed up their valuation. When interest rates are low, utility companies have less costs associated with running their businesses and this helps grow their balance sheet. When interest rates are higher, they have more costs, and their balance sheet weakens. So as interest rates lower, the stock prices go up, but when they rise, the stock prices lower. Also, since these companies typically pay out a dividend, investors are looking to these companies to supplement the lack of income they are receiving from bonds.
When the artificial demand goes away, it will inevitably lower bond prices, raise interest rates, and cause losses for bond holders. What is worrisome is that there are now products that guarantee daily liquidity for an illiquid asset. Bond ETFs can be a problem in a time of panic. Why might there be a panic in the bond market?
A 30 plus year bond bull market may be coming to a halt. In 1981, the 10-year treasury rate was above 15%, and in July of 2016 the rate fell to 1.49%. Because of such a long market run, a lot of investors may not know how to handle a fall in their bond investments. With the inclusion of ETFs, investors can jump ship much easier than traditional bondholders, so they are more likely to do so. This will make their impact swift and painful, causing larger losses. Seeing large losses on bonds can make the other investors jump ship as well. As investors start to jump it will raise interest rates more and more until demand comes back.
For stocks, the higher interest rates are going to hurt the utility companies, and it will cause lower stock prices. The increased demand for dividends will also shrink because investors will eventually want to leave the higher risk asset class in stocks, and they will want to move back into fixed income.
High Liquidity
Higher liquidity has helped push all asset prices higher, stocks and bonds. When this liquidity starts to vanish, it should have the opposite effect, and prices should lower. This should mainly effect the bond market though since central banks are using it to add cash into the system. The stock market does have high valuations, but they are not inflated like the bond market. Sure, utility stocks will likely take a hit as well as inflated dividend stocks, but the strong economy makes an argument for the above average valuations in the rest of the market.
Suppressed Interest Rates
In the Austrian school of economics, suppressed interest rates are seen as a terrible thing. The idea behind it is that since interest rates are so low, investors and companies are willing to take on more debt than they otherwise would. This in turn will cause bad investments because borrowers have such an easy supply of cash. Eventually these bad investments, which would not have been funded during a normal interest rate period, will fail and harm the economy in the long run. Now central banks say they are being careful, and do not necessarily see a lot of bad investments taking place. However, a look into auto-loans shows an eerily similar picture to the financial crisis.
Millions of cars have been sold over the last few years. In fact, there have been record breaking sales numbers over this time period. However, when you look into the loans themselves, there are an alarmingly large number of investors that did not qualify for the loans. These sub-prime loans were the cause of the housing crisis, and now there is a buildup of them in the auto-loan sector. Sure, this time it may be different, for one cars are not as big of an asset as housing, but this does give some sense of how persistently low rates can lead to bad investments.
The Unintended Consequences
In the end, all we can really say is that interest rates are going to go back up. Unfortunately, we cannot claim that they will go up fast, slow, or somewhere in between, and we cannot predict exactly how policy normalization will affect the markets and the greater economy. Using our assumptions though, there are two main takeaways. One, bond investors are going to lose money as rates go up. This could cause panic, especially now that ETFs have become a factor. Two, utility stocks and dividend paying stocks are likely to take a hit from the rise of interest rates as well. Utility companies will lose profit from the rise of rates, and dividend paying stocks will falter because bonds will eventually look more attractive to income focused investors.
Only time will tell if the low interest rates will cause bad investments, but this experiment of easy money will be looked at for generations to come. Just like the Great Depression, the Great Recession will be looked at for its faults and its glories. Economists will look back at this time period and will decipher the causes and effects of all of the policies that have been implemented, and whether or not the outcomes were worth the risks. Just as the Federal Reserve and economists everywhere learned from the Great Depression, the Great Recession will hopefully prepare us for the next large economic downturn.
Thank you for reading, and happy trading!
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Submitted October 30, 2017 at 06:00PM by BR-Technicals http://ift.tt/2xC2rhW
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