Here’s the most basic of finance/economic questions: What do low rates represent? The vast majority will answer “money is cheap and easily available”, or something to that effect.
But what if the opposite is true? How would your understanding of markets and the economy change?
According to Milton Friedman, low rates = not enough money and high rates = too much money.
After all, conventional finance/economic thinking states that interest rates are lower when money supply is higher.
Their logic is that with more money in the system, lenders compete to make loans by lowering the interest rates that they ask for. Conversely, when money is tight in the system, lenders raise the interest rates they charge since they can charge more for what is scarce.
Unfortunately, this line of thinking is inaccurate. It also happens to be one of the most widespread misconceptions held by financiers and economists.
The main reason for this inaccuracy is that it views interest rates as only representing the price of money. This is a consequence of a Central Bank-centric perspective, where people think that because the Central Bank sets interest rates, the price of money is all that matters.In other words, if the price of money has already been set low, but people are still not buying, then the price is not low enough!
This view fails to consider the other side of the equation, in this case, the borrower’s perspective. Here’s a simple example. A new business thinks it can get a return of 5% a year, and goes around shopping for a loan.
If the interest rates banks offer to it are lower than 5%, will the business take the loan? Yes.
If the interest rates banks offer are higher than 5%, will the business take the loan? No!!
Therefore, interest rates don’t just represent the price of money, they also include borrowers’ expectations of future returns.
Look back at previous bull markets, where economic conditions were also ebullient. In the dotcom mania years of 2000-2001, the US prime rate peaked at 9.5%; the mega bonus Wall Street years leading up to 2008 saw the same rate peak at 8.25% in 2006.
Both instances saw people borrowing money at rates which are, in today’s zero/negative rate environment, exorbitantly high, because they were expecting returns that were higher than those 8% – 9% rates.
Now, from this perspective, what do historically low rates in the world’s developed economies say about how businesses/investors view returns in today’s economic environment?
Historically low, of course!
The Fed just cut rates by 25 basis points, BUY BUY BUY! Fed cuts rates = buy equities might be the most Pavlovian response conditioned into market participants in modern history.
The reasoning behind it runs something along the lines of: Fed lowers interest rates = more money in the economy = good for the economy = good for stocks!
While there are many problems with this line of thinking, not least of which is its linearity, the biggest problem it faces is that it turns out to be nothing more than another fallacy.
As can be seen from the chart, rate cuts do not coincide with a rising stock market.
While Fed cuts rates = buy equities does hold true over shorter time frames, any traders who aren’t familiar with the above chart will get very badly burned; since rate cuts tend to herald large moves lower in stock markets over the medium term.
When the Fed started cutting rates in late 2007, the S&P had already topped out. A quick flurry of rate cuts after that were initially met with some cheer, and the market traded sideways for a while.
Ultimately though, the cuts did little to stop the mayhem that engulfed global financial markets as US equities sold off in sheer terror.
The Fed Funds rate tracked lower and lower with the market, until it hit a lower bound of 0%. (The Fed changed their target rate to an upper and lower limit in the midst of the crisis, instead of a single target rate previously)
The same thing happened in March 2020, when the Fed very quickly brought its target rate back to 0%, after starting to cut rates in mid 2019. The initial rate cuts in 2019 saw the S&P 500 surge to what were then record highs, only to crash back down as global markets, and the Fed, reacted to Covid.
It is important to note that the Fed starting to cut rates in 2019 shows that the US economy wasn’t in good shape even before Covid.
Over the two rate cutting cycles shown in the chart, US stocks only started rallying after rates hit rock bottom.
During the periods of time where they were being brought to 0%, US stocks sold off, in very big ways.
This makes sense, as the Fed only cuts rates when economic data and short term interest rate markets signal that conditions in the economy and banking system are starting to sour.
Such a scenario means that credit is in the process of becoming scarce, leading to lenders beginning to hoard liquidity for themselves and/or refuse to lend to riskier counterparties.
Tighter credit conditions provide the spark which lights the fire of margin calls and liquidations in the credit markets. Which, if serious enough, will spill over in a very big way into other markets, especially stocks and gold as people race to raise cash.
In other words, the beginning of fear creeping into the financial system. This fear, if supported by poor economic/political conditions, can turn an isolated sell off into a broad and vicious mass liquidation across all markets around the globe.
Obviously, none of this is bullish for risk assets, and the Fed, by cutting rates, seeks to ease credit conditions in the economy and financial system.
Unfortunately, the chart above shows that their efforts have never really worked out in the way they were supposed to.
Of course, all of this implies that the converse is true – rate hikes are not bearish for equities. Just look at the period between 2016 and 2018 on the chart, where stocks rallied as the Fed was raising rates.
Don’t be fooled by the interest rate fallacy and Pavlov’s bells!
What else is in an interest rate?
We have already seen how the interest rate fallacy plays out when people only see rates as a function of central bank policy, neglecting the fact that borrower’s perceptions matter as well.
But what about how lenders see things?
People too often assume that low rates mean lenders are having trouble making loans.
Again, this stems from having a central bank-centric perspective, where rates are seen as the price of money, set and controlled by the central bank.
From this standpoint, low rates mean a low price, hence if rates are stuck near zero, that means prices aren’t low enough to entice borrowers in.
This, however, is not the case.
Imagine that you are a lender seeing a range of clients from all across the spectrum of creditworthiness. In normal times, you would reject those who simply prove too much of a credit risk, and charge different clients different interest rates for their loans based on their relative creditworthiness.
Now imagine an economic shock so severe that it rattles your confidence in everyone’s ability to repay their loans (a la 2008 and 2020). Everyone, that is, except for those with the easiest access to liquidity and capital.
What you have now is a bifurcated loan market. One where you, as a lender, will only lend to the highest rated credits, and not to anyone else.
As a result, you begin to offer lower interest rates to this particular subset of your clientele in order to entice them to borrow from you.
But they won’t, simply because they already have ample capital, as well as ample access to it, which makes you offer them loans at even lower rates.
All this while, the people who would have to pay higher rates for borrowing simply are not offered any credit, and are locked out of the credit market.
In addition, low rates must also be considered from the perspective of the repo market.
In this case, low and negative rates demonstrate exceedingly high levels of demand for collateral, especially in higher quality issues like AAA corporate bonds and sovereign debt. Naturally, this is caused by the same kind of crises that pushed lenders to only offer credit to the safest counterparties.
This general state of risk aversion on the part of lenders, as well as repo market dealers and participants, can be traced back to the Great Financial Crisis of 2008.
As such, it has been over a decade without any policies to help people regain access to credit, or to address the role and importance of the repo market (and its collateral issues).
Is it any wonder that today’s rates are stuck at historic lows?
Earnings season is upon us again. While this is not something that is typically considered to be “macro”, everything is connected, and more often than not micro and macro factors affect each other.
In the case of 2Q earnings, this is best exemplified by Wall Street banks’ struggle with loan growth. Or rather, the lack of it.
Here’s how some of them described loan growth over the course of 2021:
“In terms of overall loan growth and importantly the growth of interest-bearing balances, that’s going to be a little bit of a slough through the rest of this year,” (Emphasis ours) – Jeremy Barnum, CFO, JPMorganFrom the FT
“tepid loan demand” – Charles Scharf, CEO, Wells FargoFrom the FT
Looking at the data, we can see that the volume of loans made to businesses has indeed been falling, and continues to fall after the sharp Covid induced spike. Growth rates are also stuck in negative territory, and have been falling for slightly over a year.
From the consumer standpoint, volumes and growth rates have begun to move higher, but remain below their pre-pandemic levels.
Supposedly, this is all due to loan demand being weak. Which, at first blush, makes a lot of sense since the economy is still recovering, and a high degree of economic uncertainty still lingers.
Who would want to borrow money when they don’t have a high degree of confidence in being able to pay it back?
But, and it is a big and significant but, this perspective neglects to consider the context surrounding weak loan demand – interest rates are at historic lows.
This is well known, widely reported, and easily observable from the near zero yields throughout the US yield curve.
Here’s the Prime loan rate for US banks:
As you can see, ever since the start of the pandemic, the Prime loan rate has fallen back to its all time low of 3.25%, first reached during the Great Financial Crisis in 2008. Which means that banks are seeing weak loan demand even as interest rates sit at historic lows.
Clearly something doesn’t add up here, but what?
To be continued…
Recognizing that loan growth is weak even though rates are at historic lows expands the list of possible causes.
Instead of banks’ simple explanation of demand for loans being low, which is the equivalent of blaming consumers and businesses for not wanting loans, we can see that there are other ways of looking at the situation.
One possible other perspective is, if loan demand is weak even though rates are so low, then rates aren’t low enough. It comes down to simple carry trade economics, the rate of return must > cost of carry.
Put another way, businesses will not borrow to invest if they do not believe that they can earn a rate of return on their investment which is higher than the interest rate on the loan.
What is interesting about this perspective is that it allows us to see that low rates are much more than a function of central bank policy – they are a boots on the ground reflection of the lack of future growth.
However, this point of view is still limited as it only considers one dimension of the problem, demand, and neglects the other – supply.
But why would banks be complaining about tepid loan demand if supply was an issue?
Simple, because loan demand is tepid within the segment of the consumer/business population that banks are willing to lend to. In other words, the number of businesses/consumers that banks deem to be creditworthy enough to lend to is smaller than it was before.
This makes sense because banks do not exist in a vacuum, they exist in the same economic ecosystem as their clients, the businesses and consumers who bank with them.
This means that if businesses aren’t borrowing because of their concern over future growth prospects, banks aren’t going to be willing to lend for the same reason. Banks are businesses too, and they must manage the level of risk they are taking in relation to the broader economic environment, lest defaults blow up their balance sheets.
Of course, this unwillingness to lend does not extend to the entire population, and banks are still willing to lend to some clients, but only the most creditworthy ones. However, the most creditworthy clients are also the ones who have the least need for loans.
This is because they already have plenty of capital – it’s why they’re considered to be the most creditworthy in the first place! In response, banks slash the rates they offer to these clients, causing interest rates to fall even further.
Consequently, access to bank lending becomes bifurcated, with those who don’t need it having cheap and plentiful access, while those who do remain locked out.
Ultimately, loan growth and the interest rates that follow come down to basic economic behavior of both the clients who demand it, and banks who supply it.
Both sides look to take care of their own interests, leading to market outcomes which are counterintuitive and opposite to what we all learned in school, but remain logical.
That’s why it’s called the interest rate fallacy, and all that is required to understand it is a change in perspective!