Since the crisis of 2008, Central Banks in advanced economies have been pushing interest rates lower and lower and in some cases even into negative territory in the hope of reviving economic growth in the country. This has meant that for over 8 years the global economy has experienced near zero interest rates. With an average annual economic growth rate of 1.8% in advance economies since 2009 (compared to 2.7% between 2000 and 2007), it is fair to say that this policy of low interest rates has failed in its objective.
But, a low interest rate regime does lead to credit growth, and this pattern has held, with total credit in the American economy increasing by an average of 16% on a 4-year forward basis (method explained below) since the start of the near zero interest rate regime in 2008. Thus, there arises a question of what this additional credit is being used for?
The answer lies in the speculative use of this additional credit.
Margin Credit and the Federal Funds Rate
The above chart shows the relationship between the change in the demand for Margin Credit in the economy of the United States of America and the Federal Funds Rate between 1959 and 2016.
Borrowed funds used for speculation in financial markets is known as Margin Credit.
Here the change has been measured on a 4 year forward basis.
For example, the observation for January 2003 is:
4-year forward increase in Margin Credit = $141 billion
Federal Funds Rate = 1.24%
This means that during the 4-year period starting January 2003, Margin Credit increased by $141 billion.
As can be seen from the above chart, post the year 1990, the federal funds rate and 4-year forward increase in margin credit has been negatively correlated. This implies that margin credit and the federal funds rate move in opposite directions. To be precise, the correlation is -0.64 or a moderate negative correlation.
Prior to the 1990’s, the correlation between margin credit and interest rate was 0.55 or a moderate positive correlation. Thus, there has been a behavioral change of people between these two time periods. This behavioral change can be explained by a survey conducted by Dr. Robert Shiller in his book irrational exuberance. The results of the survey show that prior to 1990’s people felt that stock markets were a hedge to inflation, thus, they moved up/down along with interest rates. Post the year 1990, people feel that the stock market moves in the opposite direction of interest rates. The above chart validates this hypothesis, i.e. margin debt has increased with an increase in interest rates prior to the 1990’s, while post the 1990’s, margin debt has increase subject to a fall in interest rates.
Post the crisis of 2008
On a percentage basis, the average 4-year forward increase in margin debt has been 76% since the crisis of 2008, when the near zero interest rate regime began. This compares with an average 4-year forward increase in total credit of 16% during the same time period.
There have been two major bubbles in the American economy since 1990, the dot-com bubble of the late 1990’s and early 2000’s and the housing bubble of the mid 2000’s. Both these bubbles correspond to the given peaks in the above chart. Both these bubbles were also preceded by a period of low interest rates in the American economy.
Now, we have a new spike which has formed in the above chart. For a sustained period of time, margin credit has been growing at rates comparable to those of the dot-com and housing bubble. This has been fueled mainly by the prevailing low interest rate regime.
As the previous two instances post 1990 have shown, a period of low interest rates is generally followed by the bursting of an economic bubble. Thus, it would be important to identify possible markets which are in bubble territory.
Markets to be observe closely
Stock Market: S&P 500
Cyclically adjusted price earnings ratio or CAPE is the share price divided by the 10-year average of earnings per share.
As can be seen from the above chart, with a CAPE of 28.46 in January of 2017, the stock market is above the historical average CAPE of 19.86.
While this may be higher than the historical average, a CAPE of 28.46 would probably not qualify the stock market to be in bubble territory. However, it would be prudent to observe this market closely.
Bond Market: U.S. 10-year and 30-year treasury
Method of calculation: Inverse of treasury yield rates with 1990 as the base year.
Since the start of the near zero interest rate regime in 2008, the above implied treasury price indices have fluctuated greatly. They hit their peaks in August of 2016, with a gain of 158% and 108% for the 10-year and 30-year respectively since the start of 2008.
With interest rate at their lowest possible point, realistically, there is no fundamental reason for treasury prices to keep rising. With interest rates set to rise in the U.S., the recent treasury sell-off gives us a glimpse of what may happen when rates actually start rising. With treasury prices having fallen by 45% and 31% for 10-year and 30-year treasuries respectively at the mere suggestion of higher interest rates, it is essential to evaluate the fundamentals of the treasury market before any fresh investment are made.
In conclusion, low interest rates may not have yielded their desired result, but it may have left some unintended consequences. With margin credit growth at extremely high levels, there may be a case for a market reversal once interest rates start rising. Of the two markets I have presented, the Treasury market looks more likely to have moved away from its fundamentals as near zero interest rates cannot last forever. But more importantly, there needs to be further debate on whether or not the side effects of low interest rates justify using it as policy tool to boost economic growth.