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30th May 2019 | Michał Karol Ejdys | Portfolio Quantitative Analyst

What happens if low interest rates stays with us for longer?

Since the crash of 2009, most financial authorities around the world (at least in the developed counties) had introduced interest rates as low as zero, or even in the negative, to spur investments and so that deflation is not allowed to happen.

Low interest rates cause a chain of effects

Firstly, it is cheaper to borrow money, both for companies and individuals. Companies can use this opportunity to invest in exploring new technologies, establishing a presence in new markets or just increasing production capacity. This in turn, if successful, should result in increased revenues and hopefully earnings. Companies that earn more are usually worth more, which usually translates to higher stock prices and, hence, the end of the recession and start of a bull market. This is exactly what we have seen in the last 10 years.

But there are two sides to every coin. The low cost of debt can also mean that retail and professional investors can leverage more. In both cases, it can lead to overly inflated asset prices, e.g. property for the former, stock market for the latter. Overly inflated asset prices are also known as bubbles because, after some time, when the market realizes the valuations are not justified and when the easy access to the money is taken away then the bubbles burst. 

It has to be said as well that, in both situations mentioned above, there is another thing that can go wrong. With access to debt so easy, all market participants are more likely to make more careless investments. Money placed in such ventures is likely not to be repaid more often and this causes problems within the banking system, which, as we have seen in the recent crisis, are bound to propagate through the entire economy.

Not only carelessness but also unanticipated economic factors can cause problems with repayments. When most bank loans are lent at a variable rate, and at some point, rates begin to rise, so will the interest payments. History shows that a sizable population borrows as much as possible, while being barely able to service their payments. If the payments grow, they go bankrupt. 

The previous analysis has been focused on banks as a source of debt, but in fact, there is one more important stage in the chain of events, that comes before even them. Banks source the capital for lending from deposits placed and held with them. In a low interest rate environment the bank deposits pay less, and hence people are less incentivized to place money there. They look for alternatives. At the same time, the demand for debt is high, which contributes to a mismatch between banks assets and liabilities, as well as a decrease in their profitability.

So, what happens should low rates continue?

The simple answer is any or all of scenarios above. What we can say now, though, is which of them happened and which are happening now.

With all certainty, we can say that lowering the investment rates to spur investments has worked. Since 2008, we have been enjoying an uninterrupted bull market, at least in the US. That is ten long years of constant, year on year, gains, which is an incredible achievement.

However, talk that stocks are already overvalued are being heard more clearly now, and this argument holds a lot of merits. For example, tech stocks have been trading on all-time-high valuations for a couple of years now. This could point us to the bubble scenario should the rates stay low.

As for various credit events, such as the banking system failure over bankruptcies, it looks like we can remain calm for now. The extensive reforms which have been conducted after the Great Financial Crisis seem to have worked. Banks have a lot of spare capital, and their capital structures are sound. On the other hand, problems with insufficient credit checks have also been fixed, and customers are screened properly now, which should prevent excessive debt taking. Even though it has been long said there are a lot of delinquencies in car loans in the US, no data shows this should evolve into a major crisis.

The bottom line

To sum up, there are various scenarios that could develop should the interest rates stay low, most of them negative. However, so far there is little evidence we should be on the brink of any of them, and interest rates are rising throughout developed economies, which should steer us into more positive directions.

Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication.
All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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