Skating on thin ice - March 15, 2015

Central banks cutting interest rate to zero or below zero might be quite risky. The constant money pump and the quantitative easing programmes had already put pressure on the government bonds yields, in addition, these last months, European bond yields has fallen to a record low (even the Italian, Spanish and Portuguese bonds – no more panic like a few years ago?). This all drove short and mid-term bond yields negative. Moreover, ECB’s QE programme, launching in mid-March, can put more pressure on yields and keep them on minimum low. The reason to all this is to boost European economy, to promote lending and to reduce the funding cost of debt service. However, politicians become idler as having these convenient conditions mean they can postpone structural changes that could have ensured long term economic stability. Interest rate can obviously not stay this low forever and once they start rising, honestly, many countries will not be prepared for its negative impact.

Moreover, personal and non-personal savings will be affected by the record low interest rates as investors’ money will not bring in interest but will worth less. A global yield hunt began and people are started to take more risks; when the interest rate is zero or below zero, every asset is worth buying just to have some yield. Thus, all over the world, asset prices inflating, money is flowing into stock markets and real estates. It is quite possible that stock markets’ prices continue to rise and deviate from the usual valuations we got used to. It is also quite possible that we will be facing asset-price bubbles in the upcoming years, as on the bond market it has already been happening. The danger and consequences of this can be severe. If inflation kicks-in, central banks have no choice but to react in form of interest rate rising which might result in immediate bond yield rise (i. e. exchange rate drop). If, for instance, the German 10-year government security yield rises from current 0.2 per cent to 5 per cent (the last time this level was shown in 2002) investors holding this security would lose 40 per cent of their money. Rising interest rates could result in even more serious consequences on the stock markets’ and real estate valuations and generating price fall due to changes.

All in all, it seems that central banks’ zero interest rate can hardly help the real economy because companies do not invest significantly more and the private consumption has not increased either after the lower interest rate credits, because of the current deleveraging in Europe. It is mostly the upper class who can profit from it, those who already have assets (securities, real estates, other real goods); as the higher the prices become the bigger their fortune grow.

If we look at the bigger picture, a normal (1-2 per cent) interest rate would be much healthier; it would still be able to help the economy but would not blow asset-price bubble. Thus, an adjustment process could start (obviously, its degree and way of realization is important) and have a great impact on the global economy and stocks. Until then, let’s look for the signs as still, passengers are boarding this train and money flowing into the markets, and European economy is expected to recover. Accordingly, investors will continue to buy everything that can have an output: stocks, bonds, real estates. Thus, there is no need to put the cart before the horse but the right risk management becomes even more important.

By Innovative Securities

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