A potential reason for another crash

Fri, 8 Oct Pre-Open

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Interest rates are any central bank's favorite tool when it comes to stimulating demand in an economy. In a bid to stimulate demand in an economy caught up in a recession, the first thing central banks will do is to lower interest rates. The lower interest rates (or cheaper money in other words), they hope, will cause consumers to be more generous with their spending as they have a lesser incentive to save. Lower interest rates also mean that it is cheaper for businesses to borrow. Thus, central banks also hope that businesses will use these cheaper funds to step up their investments in capacity expansion. Again, another stimulus to activity and aggregate demand in an economy.

And so, central banks around the developed world have been working overtime to decrease and sustain lower interest rates. To the point that, as per a Bloomberg report, in the UK, the benchmark is 0.5%, the lowest since the Bank of England was founded in 1694. In the euro area, the main refinancing rate is 1%, the lowest in the European Central Bank's history. In the US, the Fed slashed rates 1 year to a record 0.25%.

But just like an overdose of a medicine has side effects, a policy of sustaining ultra low interest rates, albeit with noble intentions, too has its side effects.

Savers who have cash to spare are unhappy lot. They earn next to nothing on their savings if invested in safe instruments like government bonds. And so they've moved on. On to more riskier but higher yielding assets. And this desperate search for higher yields is leading masses of investors to assets that they would otherwise probably not buy.

As per Bloomberg, sales and prices of junk bonds are soaring. Companies in the US have issued a record number of non-investment-grade bonds in 2010. Year to date, such debt issuance have almost doubled compared to the same period last year. Companies with lower than average credit ratings are finding it easy to borrow at unbelievably low rates. Property markets in places like the UK are also feeling the effects. All time low interest rates on mortgages are creating a false sense of security among buyers who have begun to feel that interest rates will remain this low forever. Money is finding way into commodities too, where the prices of some commodities have been going through the roof.

Investors from developed countries are also rushing into emerging markets. Interest and growth rates in these countries being significantly higher are driving these investors' decisions.

And so, the great mispricing of assets has begun once again. Ultra low interest rates during a crisis is understandable. But sustaining such absurdly low rates for so long is distorting asset prices the world over.

If this continues for long, the world will indeed have a tough time readjusting to higher rates. And rates will eventually trend higher as and when inflation catches up. More so in light of the drastic increase in money supply in the last two years or so. All in all, setting the stage for perhaps yet another domino of crashes as asset prices fall in response to the higher rates.