Low interest rates create an incentive for retail investors, hedge fund managers, and banks to consider riskier assets that offer higher returns. Cheap money also makes it easy to borrow when the return exceeds the cost of borrowing.
When short-term interest rates are low and unstable, investors are hesitant to borrow more and leverage their position. But when interest rates are stable, investors are more willing to assume the risk of borrowing to invest in long-term and high-yield securities.
Please look at the chart below.
Chart courtesy of www.StockCharts.com
As of April 1, 2015, the effective Federal Funds Rate is at 0.120%. Over the last six years, the Federal Reserve has purposely kept the Funds Rate close to zero.
Don’t Forget What Caused the Financial Crisis in 2008
Back in 2005, Raghuram Rajan, the chief economist of the International Monetary Fund (IMF), gave a captivated audience at Jackson Hole a presentation that no one expected. Despite robust financial and economic conditions, Rajan was unmoved.
Rajan argued the increasingly complex financial market and financial instruments like mortgage-backed securities and credit-default swaps made the global financial system very risky. At the time he made his comments, no one took him very seriously. (Source: International Monetary Fund, August 27, 2005.)
Three years later, in 2008, his ideas were proven right.
Is It Déjà Vu All Over Again?
Today, Rajan is the governor of the Reserve Bank of India; and he is worried again. This time he is concerned about U.S. monetary policies as well as the monetary policies of other central banks; like the European Central Bank keeping interest rates artificially low.
Artificially low interest rates and easy money policies could have long-term repercussions in the global financial markets.
When central banks come to the so-called rescue and keep interest rates artificially low for extended periods of time, markets become overvalued and asset prices are lifted far beyond the fundamentals.
Let’s take a closer look:
The Federal Reserve is expected to raise interest rates in September. Should this happen, many expect signs of rising inflation to negatively impact the markets. I talked about how the weak recovery, massive budget deficits, and high debt levels could push the fragile U.S. economy into another recession in a previous article. I also discussed how China, the world’s second-largest economy, is also losing steam. (See “Global Economy Remains Weak; Another Recession Coming?”)
Consider this: with the stock market trading at a record high, the last thing investors would expect to hear is that more turmoil could be just around the corner. I will not be surprised if the U.S. economy enters a recession in late 2015 or early 2016.