A Bubble in Search of a Pin – The Unintended Consequences of Low Interest Rates

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A Bubble in Search of a Pin – The Unintended Consequences of Low Interest Rates


World’s Central Banks Lowered Interest Rates

In response to the Great Recession of 2008, The Federal Reserve and other central banks of the world artificially lowered interest rates. Their thinking was that lower interest rates would spur economic growth.

So the Fed has left rates near zero for about eight years.  The Japanese and European central banks have gone even further by introducing negative interest rates as a means of stimulating their respective economies.  So how have they done?  Have they successfully promoted economic growth?  Unfortunately no.  After eight years of ultra-low interest rates the world economy is teetering on recession.

But the Fed believes its policies have worked, that without their strong intervention the Great Recession would have been far worse.  Other respected economists believe otherwise.  They believe The Federal Reserve policies of interest rate repression and quantitative easing have thwarted the normal recovery process.  I generally agree with their opinion but that’s not the point of this article.

Regardless of who’s right and who’s wrong there are several unintended consequences.  So let me first begin by identifying the winners and losers resulting from the decisions made by the world’s central banks.  And then let’s look at potentially the most egregious unintended consequence of low interest rates which is still looming on the horizon.

Winners

  1. Homeowners with a mortgage

    For many people, their mortgage payments are the largest part of their disposable income. The significant reduction in mortgage interest rates has resulted in lower mortgage payments and more discretionary income for homeowners to spend.  Want to read more on this subject? Read Why U.S. Treasury Rates will Continue to Decline.

  2. Government debt payments 

    Bond yields, i.e., the rate at which the federal government borrows, have fallen dramatically.  This means that the interest payments the federal government pays on the national debt is substantially lower than if bond yields had remained at levels prior the Great Recession.

  3. Investors in commercial real estate benefited two ways:

    • Capitalization rates are inextricably tied to interest rates. As interest rates declined, cap rates declined making their CRE investments increase in value.  Want to read more on this subject?  Read Cap Rates Too Low? Heck No! Find Out Why.
    • As investors refinanced their properties at lower interest rates, mortgage payments have been reduced increasing their properties cash flow after debt service.

 Losers

  1. Savers 

    The most obvious losers from low interest rates are savers. Retirees living off income from bonds and dividends are hit hardest by The Fed’s monetary policies.

  2. Banks 

    It makes it that much harder to attract deposits when the interest rates they offer are so low.

  3. Renters

    People who rent are the biggest losers. Not only do they not receive the benefit of lower mortgage payments, in many instances their rent has increased dramatically due to other forces unrelated to The Fed’s policies.    

  4. The Poor

    Falling interest rates for mortgages and personal bank loans benefit those customers who tend to be more affluent. Lower income people are unlikely to benefit at all because interest rates on sources of debt they rely on, such as credit cards or pay day loans, have not fallen at all.

The Real Unintended Consequence – Asset Bubbles

Yes, those are the winners and losers of low interest rates.  But the real problem with low interest rates is that they create asset bubbles.  An asset bubble is formed when the prices of an asset rise so sharply and at such a sustained rate that they exceed the valuations justified by market fundamentals.  I believe that Fed policy over the last eight years has created several asset bubbles.

Stock Market Bubble – Potential for Disaster

The one I’m most concerned with is the stock market.  Over the past several quarters companies that comprise the S&P 500 have seen declines in revenue.  Meanwhile, Price/Earnings ratios, arguably the most accepted indicator for checking if stocks are overpriced, continues to climb.  In fact, since 2014 the S&P 500 P/E ratio has been increasing at an accelerated rate.  This defies logic.

The most egregious effect of low interest rates is to potentially destroy the retirement hopes and dreams of those who have retired or are near retiring.  How you ask?  Those at or near retirement have been forced to shift their investments from very safe asset classes, such as money market funds, bonds, annuities, etc. to asset classes that are significantly riskier, like stocks, junk bonds with higher yields, and commercial real estate.  They’ve done this to increase their returns on their investments because the low risk assets no longer generate sufficient returns.  In other words, at a time when they should be reducing risk, they are forced to increase it.

What will Pop the Bubble?

By forcing retirees to invest their retirement savings into riskier asset types, more and more money has been invested in the stock market at a time when corporate profits are on a decline.  This is the classic definition of a bubble, a bubble that is waiting for a pin to pop it.  What might be the “pin?”  Who knows.  My guess is some bad economic news overseas will be the instigator of a series of calamitous events that will eventually cause the bubble to pop.  There are many well-meaning economists and financial advisers who strenuously disagree with my assessment.  I truly hope that they are right and that I’m dead wrong.  Because if I’m right, when these bubbles burst it will take the retirement dreams of millions of Americans with it.

Like what you’ve read?  Download my FREE Top 5 Blog Posts to Make You a Better Investor.


Sources: Federal Repression System, by John Mauldin, Mauldin Economics, October 9, 2016; Fed Creates Junk bond and Stock Market Bubble, by Alex Pitti, seekingalpha.com; Winners and losers from low interest rates, Tejvan Pettinger, Economics Help, July 10, 2016; Asset Bubble Definition by the Financial Times Lexicon; Is There A Stock Market Bubble? Evidence Suggests Caution is Necessary, APAC Investment News, April 5, 2016.


6 Comments

  1. Rennie October 31, 2016 at 11:36 am - Reply

    Hi Doug, Thank you for your insights and opinion. I do not know who will be right or wrong, but it is important to see both sides of the coin.

    • Doug Marshall
      Doug Marshall October 31, 2016 at 12:24 pm - Reply

      Thank you for your comments. Regardless of who is right about The Fed’s monetary policy (did their policies help or hurt the recovery) they have created several asset bubbles. I have two questions: 1) When will these asset bubbles pop? and 2) How severe will be the correction?

  2. Jim Davis October 31, 2016 at 3:39 pm - Reply

    Hi Doug , do you think the dollar will be replaced soon by another currency and if that happens what will be the results?

    • Doug Marshall
      Doug Marshall October 31, 2016 at 4:05 pm - Reply

      Good to hear from you Jim. I haven’t heard any rumors of the dollar being replaced by another currency. In recent years the dollar has been appreciating against most world currencies and this is having a detrimental affect on those countries whose debt is in dollars. More of their currency is needed to pay down their debt than if their debt was not in dollars. So if I were them, I would avoid having my debt in U.S. dollars and use another currency such as the Euro. But as for now, most countries prefer the dollar over any other currency. When that changes look out.

  3. Lawrence Cahn November 2, 2016 at 12:53 pm - Reply

    Commenting from the real estate side, the low-interest rates, and low cap rates environments will disappear. While the resulting cost of operating a property will increase, the higher cap rates will make the property worth less than it is currently hypothesized to be.

    Over the last six years, rents have accelerated at a very rapid rate and there is very little room for rents to grow. This rapid percentage of rent rise far exceeds the corresponding percentage of growth in income from people in B & C properties. Ten years ago, renters paid about 32% of their annual net income to rents. Now that has jumped to about 50%, leaving little discretionary funds for these renters. With a damper on discretionary spending, the disparity in income levels and the corresponding apartment rents, and the inevitable coming recession, the process will feed upon itself making the impact on real estate far worse than had interest rates not been artificially kept low.

    My forecast is that rents stabilize within the next six months, and then rents will come down by about 20%; this rental reduction will occur over the next five years. Property prices will decline by 15% before rising once again.

    • Doug Marshall
      Doug Marshall November 2, 2016 at 3:15 pm - Reply

      Lawrence thank you for your well thought out comments. I agree with your assessment that apartment rents are at their peak especially for Class A apartments. It’s hard for me to believe they can continue rising. It’s very likely that they will start leveling off in the Portland market. But where I respectfully disagree is about the low interest rate environment not continuing. It will continue and I wouldn’t be surprised if they continue trending lower. With negative interest rates in Europe and Japan the United States cannot act independently from the rest of the world on monetary policy. It’s not possible. And if we see a recession in 2017, will The Federal Reserve put pressure on interest rates to rise? Not a chance.

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