Low Interest Rates Lead To “Financial Engineering at Its Height”
The irony of low interest rates
In a video on his website, Carl Icahn shared his views on the low interest rate regime in the United States. According to Icahn, “the irony of lower interest rates is while you think it’s going to help create jobs, it’s not happening.”
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As outlined in the above chart, the Federal Reserve’s balance sheet has mushroomed from less than $1 trillion to over $4.5 trillion over the past six years. It believed that low interest rates would prompt companies to invest more in their businesses, leading to expansion in economic activity and jobs. The Fed thought that low interest rates would assist in increasing productivity in the economy.
However, if you look at the figures today, the rate of productivity is at an all-time low, and property such as plants and equipment is older than it’s ever been.
Companies are making earnings through financial engineering
Companies are making use of cheap available credit to acquire other companies or to buy back their shares, rather than investing more into their existing businesses. Companies like Apple (AAPL), Prudential Financial (PRU), and IBM (IBM) have been the forerunners of the share buyback race. Many of these companies raise credit by issuing high-yield debt, such as “junk bonds” (JNK), which are high-yield bonds (HYG) issued by below-investment grade corporations. They’re popularly referred to as “junk” due to the low ratings and high risk of default attached to these bonds. Risks in terms of ratings and default are compensated for by the high yields these bonds offer.
Financial engineering leading to a bubble
Corporate America is using low interest rates to its advantage, through financial engineering and by taking over companies. The “financial engineering” that Icahn refers to has had two major effects:
- It has been crowding out middle class investors from the investment grade and treasury bond (SHY) markets. These investors are prompted to turn to stocks or even risky junk bonds in search of yield.
- At the corporate front, companies have been issuing junk bonds to buy other companies. The mergers and acquisition business, as Icahn noted, has zoomed from $1.3 trillion in 2007 to $2.3 trillion in 2015.
Icahn reminds viewers that it was the low interest rates in 2002 and 2003 that eventually led to a catastrophe in 2008 and 2009, popularly known as the credit crisis or the housing bubble. In the next part of this series, we’ll look at the bubble that is being created today.