The Impact of Low Interest Rates on Investments

Low Interest Rates and Investment Behavior

The global investment landscape is akin to a flock of birds on a crisp spring day – easily swayed by the wind. The allure of higher returns often leads investors to seek out riskier assets when the safe haven of bonds offers meager yields. In recent years, we have witnessed this phenomenon: as bond yields declined, the demand for riskier assets surged, driving up valuations for equities, real estate, and private equity. This, however, poses the danger of asset inflation and potential bubbles, reminiscent of the market tumult in late 2020 and throughout 2021.

The Risks of Low Interest Rates

Low yields on safe investments create a financial environment where prospective returns are dismally low. In such circumstances, investors, who stubbornly cling to their desired returns, find themselves at a crossroads. Pressed for higher returns, they are compelled to venture into riskier territories. This shift in behavior – from the safety of low-returning assets to the allure of high-risk, high-return investments – symbolizes a worrying trend. Indeed, in the words of my late father-in-law, these investors become ‘handcuff volunteers’ – akin to reluctant adventurers coerced by circumstances rather than choice.

This phenomenon inevitably leads to a mass exodus of capital from the safety of low-return assets to the allure of high-risk opportunities. Consequently, the demand for these riskier avenues escalates, propelling asset prices skyward. While this trend may initially yield lucrative gains for risk-takers, it also fosters a culture of speculation that can have detrimental consequences in the long run.

Historical Precedence of Speculative Movements

A glance at history reveals that periods of low interest rates are often precursors to speculative frenzies. As John Fullarton observed in 1844, during times of low interest, the pursuit of value assumes an exaggerated façade, and every article becomes a subject of speculation. This euphoric financial climate spurred by declining interest rates often paves the way for ill-advised investments, triggering a surge in speculative ventures.

The Impact on Risk and Return

When central banks lower the risk-free rate, a domino effect ensues. The entire yield curve, the governing asset-class returns, and the liquidity premium cascade downward. This downward spiral not only reduces returns but also diminishes the risk premium, compelling return-seeking investors to embrace illiquid investments. The consequence of this downward shift is the inadequacy in compensating for the heightened risk associated with longer-term, riskier, or less-liquid assets.

The Perils of Misguided Investments

As Friedrich Hayek astutely pointed out, the decline in interest rates propels businesses to invest in projects with distant payoffs. This hasty expansion of the ‘structure of production’ often results in ‘malinvestments’ – a term popularized by Austrian economists. These malinvestments, in their many guises, range from extravagant white-elephant projects to far-fetched technological schemes devoid of any profitability prospects.

These trends are documented with a touch of gallows humor, such as Argentina’s issuance of 100-year bonds in the low-return environment of 2017. The seductive yield on these bonds at 7.85% enticed investors, only to culminate in a default within three years. This highlights the dangerous allure of high returns in low-return settings, leading investors down a treacherous path that ends in financial turmoil.

Fool’s Gold: Illusions of Lucrative Returns

Easy-money conditions often create an illusory perception of the attractiveness of long-dated bonds, with their enticingly higher yields. However, these long bonds, much like a siren’s call, are more susceptible to interest rate changes, making investors vulnerable to swift price declines. Similarly, the allure of “long stocks,” representing companies promising exponential growth, poses similar risks akin to a mirage in the investment desert – the promise of bountiful returns but fraught with perilous volatility.

Ultimately, the undercurrent of low interest rates is akin to a tide that lures investors to uncharted waters, seducing them with the allure of higher returns. However, this fanciful allure often masks the treacherous undertow that imperils investors, leading them into unwise and perilous investments fraught with risk and uncertainty.

Impact of Low Interest Rates on Investment Behavior

Investors, drawn by the allure of higher returns and displaying reduced risk aversion, gravitate towards stocks with promising future cash flows when interest rates are low. These “growth stocks” tend to soar during times of relaxed monetary policy and take a harder fall when liquidity dries up. This was markedly evident in the late 2020s and in 2021, while 2022 saw a contrasting downturn.

The Temptation of Malinvestment

Low-return periods often witness the deployment of capital into unwarranted ventures, constructions, and ventures, fueled by the need to seek higher returns in a low-yield environment. The investment landscape becomes marked by flexibility and aggressiveness, sidelining careful due diligence and risk-averse strategies.

The Proliferation of High-Risk Deals

In times of low interest rates, deals become easily financeable and attract investors due to their allure. This easy money scenario leads to an influx of capital for ventures that would otherwise be met with skepticism, reflecting a shift in market sentiments and appetites for risk.

Amplified Fragility Through Leverage

Low interest rates spur the use of leverage, akin to ketchup making less appealing investments palatable. This facilitates heightened speculative activities and rapid expansions, but also increases the susceptibility of companies to financial turmoil in the event of adverse market conditions.

Financial Mismatches and Asset Liquidity

The allure of borrowing at low short-term rates to fund long-term investments increases during periods of easy money. However, mismatches in the maturity of liabilities and assets can leave borrowers holding illiquid assets when lenders call for immediate repayment, creating financial distress.

Expectations from a Low Rate Environment

Protracted periods of low rates breed an expectation of continuity, leading to a normalization of the situation and potentially igniting further risky behavior as investors grow complacent in their anticipation of perpetually low rates.

The Never-Ending Impact of Low Interest Rates

Low interest rates can act like a siren’s song, luring borrowers with the promise of cheap capital while leaving savers and lenders at a disadvantage, a scenario that has been repeated throughout financial history and currently continues to shape modern economic landscapes.

Unforeseen Consequences of Low Interest Rates

While the allure of low interest rates may be appealing, the ramifications can be more far-reaching than investors and policymakers anticipate. An environment of perpetually low rates may lead to assumptions about the cost of capital that could spell trouble when financing is sought at higher rates, jeopardizing real estate projects and other long-term investments.

As the economy recovered from the challenges of 2020 and stock markets rallied, a prevailing belief emerged that the Federal Reserve would keep rates low, propping up the economy and equity markets. History, however, tells a different tale. Catalysts for interest rate increases inevitably emerge, and the notion of perpetual prosperity has repeatedly proven to be a mirage.

Reflecting on the 1920s, The New Lombard Street highlighted how intervention to stabilize fluctuations in interest rates led to an unstable asset price bubble, fueling the Roaring Twenties but ultimately producing an economic imbalance that resulted in a severe crash.

The Balancing Act of Low Interest Rates

Low interest rates may bestow benefits upon borrowers, but they come at a cost to savers and lenders. This fundamentally alters the financial landscape, raising the question of whether it is prudent to undermine the revenues of lenders for the sake of cheaply leveraged investments.

The impact ripples through society, affecting retirees who see their savings generate minimal returns when interest rates are near zero. Such policies have also contributed to a substantial spike in wealth inequality, benefiting the wealthy while penalizing households that rely on saving.

The resulting economic disparity has contributed to societal divisiveness, underlining the broader consequences of a central bank’s decision to set rates that subsidize some while penalizing others.

The Cycle of Risk in Low Interest Rate Environments

Low rates often induce optimistic behavior that sets the stage for the next financial crisis. The allure of cheap capital leads to increased risk-taking, underestimation of future financing costs, and heightened leverage, all of which lay the groundwork for investments that may falter when tested in periods of financial stringency, ushering in the next crisis and potentially necessitating rescue efforts.

Historically, a similar warning was issued in 1889, noting the peril of forcing too much capital into industrial developments at the expense of financial stability. Excesses in one direction frequently lay the groundwork for excesses in the opposite direction.

Lessons from the Past

Mark Twain once observed that “history doesn’t repeat itself, but it often rhymes,” a sentiment that bears resonance with investors as they grapple with the recurring cycles of financial markets. The control of money’s availability and cost and its profound impact on asset prices and the economy have been pervasive themes throughout financial history.

Over 30 years ago, a profound appreciation for the fluctuations in the availability and cost of money underscored the significance of the credit cycle. This observation remains relevant today, as investors grapple with the impacts of the credit cycle on asset prices and economic dynamics.

By understanding the metaphorical “credit window” – sometimes open and sometimes closed – one can comprehend the undulating nature of the credit cycle. Recognizing the causality of cyclical progression and the presence of “excesses and corrections” provides a more robust framework for understanding and navigating economic cycles.

• The recognition that each event in a cyclical progression is caused by its predecessors is essential for understanding and navigating cycles effectively.

• Viewing cyclical oscillation as a product of excessive departures from the norm, followed by corrections and subsequent excessive continuations, is a more effective way to conceptualize cycles than the simplistic notion of “ups and downs.”

• The interplay of “excesses and corrections” defines the cyclical nature of financial markets, underlining the need for a nuanced understanding of these market dynamics.

The Endless Cycle of Easy Money and the Financial Landscape

Any of these can be labeled the start of a cycle, providing it goes on to include all four.

While there’s no fixed point that represents the official start or end of a cycle, most economic cycles can be described as follows. Notably, each step in the cycle causes the next.

Understanding the Cyclical Process

First, stimulative rate cuts bring on easy money and positive market developments; which reduce prospective returns; which leads to willingness to bear increased risk; which results in unwise decisions and, eventually, investment losses; which bring on a period of fear, stringency, tight money, and economic contraction; which leads to stimulative rate cuts, easy money, and positive market developments.

If John Mills’ observation holds true, then panics simply reveal the extent to which capital has been previously destroyed by its betrayal into hopelessly unproductive works. A lesson that I believe investors can gain an advantage by studying cycles, understanding their causes, and watching for excesses.

. . . our modern monetary mandarins never stop to consider Bagehot’s warnings about the adverse consequences of easy money – how interest rates set at 2 per cent or less fuel speculative manias, drive savers to make risky investments, encourage bad lending and weaken the financial system. (TPOT)

What I so enjoy about Chancellor’s books is the way they illustrate the tendency of financial history themes to rhyme, as Twain would say, and thus how behavior that took place 200 or 400 years ago is being repeated today and is sure to reappear again and again in the future. What he tells is a never-ending story.

Observing the Impact of Easy Money

The behavior brought on by low rates takes place in plain sight. Some people take note of it, and a subset of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And almost no one alters their investment approach to take them into account.

When money is easy, few people opt to sit out the dance, even though the adverse results described above can reasonably be anticipated. When faced with the choice between ((a)) maintaining high standards and missing deals and ((b)) making risky investments, most people will choose the latter. Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behavior.

Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. (A Short History of Financial Euphoria)

The lessons from past periods of easy money usually fall on deaf ears since they come up against ((a)) ignorance of history, ((b)) the dream of profit, ((c)) the fear of missing out, and ((d)) the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest. These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences.

Maybe we have a new version of Lord Acton’s law: easy money corrupts, and really easy money corrupts absolutely.

The Future of Easy Money

Are you saying interest rates are going to be higher for longer? My answer is that today’s rates aren’t high. They’re higher than we’ve seen in 20 years, but they’re not high in the absolute or relative to history. Rather, I consider them normal or even on the low side.

• In 1969, the year I started work, the fed funds rate averaged 8.2%.
• Over the next 20 years, it ranged from 4% to 20%. Given this range, I certainly wouldn’t describe 5.25-5.50% as high.
• Between 1990 and 2000, which I would consider the last roughly normal period for rates, the fed funds rate ranged from 3% to 8%, suggesting a median equal to today’s 5.25-5.50%.

So no, today’s interest rates aren’t high. Having disposed of that question, I’ll move to the subject of this section: the outlook for rates.

Many of my reasons for believing we’re not likely to go back to ultra-low rates are rooted in my thoughts on how the Fed should think about the issue. But the Fed could decide to lower rates to stimulate economic growth or reduce the cost of servicing the national debt, even if doing so might be deemed imprudent. Thus, I have no idea what the Fed will do. But I’m sticking with the thinking that follows.

In my original Sea Change memo, I listed a number of reasons why we weren’t likely to go back to ultra-low interest rates anytime soon. The most salient are these:

• Globalization has been a strong disinflationary influence, and it’s likely on the decline. For this reason – and because the bargaining power of labor seems to be on the rise – I believe inflation may tend to be higher in the near future than it was pre-2021. If true, this will, all else being equal, mean interest rates will be kept higher to prevent inflation from accelerating.
• Rather than be in a perpetually stimulative posture, the Fed may want to maintain the neutral rate most of the time. This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%.
• The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century.
• Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout.

The Case for Maintaining Moderate Interest Rates Unveiled

The Federal Reserve’s role in controlling inflation is critical. To maintain a positive rate and avoid recession, the fed funds rate must exceed the rate of inflation. Cutting rates effectively during a recession is essential, but it becomes impracticable if the rate is already near zero or only at 1%.

Risks of Returning to Ultra-Low Interest Rates

Lowering rates to a stimulative level as soon as inflation touches 2% could lead to a reacceleration of inflation. Instead, the approach should focus on achieving 2% inflation and maintaining rates at a level that neither stimulates nor restricts the economy. Additionally, ultra-low interest rates could induce risk-taking, malinvestment, leverage, asset bubbles, and create economic winners and losers.

The Base Interest Rate for the Following Years

Considering the arguments against maintaining ultra-low rates, the base interest rate in the next few years is more likely to average 2-4% rather than 0-2%. While many prefer low interest rates, basing rates only on emergency measures to rescue the economy from prolonged or severe contractions seems to be economically more advantageous.

During my time at the University of Chicago, the influential economist Milton Friedman espoused the belief that free markets are the most effective allocators of resources. I am convinced that “natural” interest rates lead to the best allocation of capital. Interest rates are indeed the price borrowers pay to rent lenders’ money for a period of time, and it’s beneficial when they are set naturally based on supply and demand.

Historical Perspectives on the Natural Interest Rate

17th-century English practitioners of “political arithmetick” likened interest to any other price, suggesting that its level should be determined by buyers and sellers in the market, rather than government fiat. A natural rate reflects society’s time preference, ensures efficient use of capital, and provides a fair return for savers. In 1927, Germany’s central bank head emphasized the importance of a true rate over a low rate to maintain economic order.

The Notion of Natural Rates and Neutral Rates

Natural rates, related to but somewhat different from neutral rates, are neither stimulative nor restrictive, thus less likely to encourage extreme behavior. As posited by Swedish economist Knut Wicksell in 1936, excessively low rates can spur rapid credit expansion and inflation while excessively high rates can lead to credit contraction and price declines.

Applying Free Market Principles to Interest Rates

Since the late 1990s, the free market in money has been eroded, with the Fed becoming “activist” and intervening with liquidity injections. A return to a free market would involve lower rates to stimulate a slow-growing economy, a raise to cool off an overheating economy, and allowing market forces to determine rates in between.

Future Rate Trends and Consensus Thinking

It is anticipated that the Fed will reduce the fed funds rate from the current level of 5.25-5.50%, with the consensus among investors showing more optimistic expectations of earlier and more substantial rate cuts. However, past consensus thinking has often been off the mark, and it’s crucial to avoid relying too heavily on it.

The Pitfalls of Consensus Thinking

Consensus thinking often engenders the “Goldilocks thinking” illusion—a belief that the economy won’t become too hot to raise inflation or too cold to bring on an economic slowdown. Goldilocks thinking seldom endures for long and often leads to unexpected economic disruptions.

Sea Change in Market Expectations and Investment Landscape

It’s no secret that the current market environment is subject to Goldilocks thinking, which invariably sets the stage for potential investor disappointment and subsequent losses. The FT Unhedged recently aired comparable sentiments, hinting that the market’s anticipation of robust growth and six probable rate cuts might be skewed towards an excess of positivity.

The prevalent notion that sturdy growth may limit the Federal Reserve to approximately three rate cuts projected at present, or alternatively, subdued growth resulting in as many anticipated cuts, indicates an overestimation of favorable news by the market. (December 20, 2023)

Regardless of whether the market consensus aligns with the aforementioned view, there is a steadfast resolve to hold the belief that rates will hover around 2-4%, rather than 0-2%, over the next few years. To provide more specificity, the fed funds rate is anticipated to average between 3.0% and 3.5% over the next 5-10 years. Delving deeper into macro forecasting, it is clear that while opinions on the macro are welcomed at Oaktree, investment decisions remain grounded in bottom-up analysis of companies and securities, disregarding macro predictions.

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Implications of the Sea Change Thesis

1. The period spanning 1980 through 2021 witnessed a general trend of declining and/or ultra-low interest rates.

2. This trend had far-reaching consequences, significantly impacting the winners and losers in various investment strategies.

3. This trajectory shifted in 2022 when the Federal Reserve commenced raising interest rates to combat inflation.

4. A reversion to such lenient monetary conditions, except for temporary responses to recessions, appears improbable.

5. As a result, the forthcoming investment landscape is set to feature higher interest rates compared to those witnessed in 2009-2021. Different strategies will outperform in the upcoming period, necessitating a distinct asset allocation.

The statements of fact identified in bullet points one through three are indisputable. Consequently, the conclusion – point number five – pivots exclusively on the accuracy of point number four. The crux of the matter is simple: either you subscribe to this theory or you don’t. Should you acquiesce, a myriad of solutions will be proposed.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.