Must-know: Unusual outcomes arising from low interest rates

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Dr. Narayana Kocherlakota talks about real interest rates in Boston  

Minneapolis Fed president and chief executive officer (or CEO) Dr. Narayana Kocherlakota, spoke on the subject of low real interest rates at the Ninth Annual Finance Conference, held at Boston College in Boston, Massachusetts on June 5, 2014. Real rates of interest are the reported rates of interest, net of inflation.

In his speech, Dr. Kocherlakota mentioned that real rates of interest had fallen sharply below 2007 levels, and five-year Treasury Inflation Protected Securities (or TIPS) yields were currently in negative territory. In this section, we’ll discuss some of the “unusual financial market outcomes” mentioned by Dr. Kocherlakota, resulting from low real rates of interest. We’ll also discuss the impact of these outcomes on the bond (AGG) and stock (VOO) markets.

Part 3

Inflated asset prices

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Long-term assets are able to be substituted for each other. When real interest rates decline, the prices of long-term bonds increase because bond yields and prices move in opposite directions. Investors generally respond to the low yields on long-term bonds by substituting them with other long-term asset classes (for example—gold, land, and stocks, among others) which increases their prices, spiking them higher than their historical norms.

Unusually volatile asset returns

Dr. Kocherlakota also stated that lower real interest rates increase the price volatility of asset returns. “When the real interest rate is very high, only the near term matters to investors. Hence, variations in an asset’s price only reflect changes in investors’ information about the asset’s near-term dividends or risk premiums. But when the real interest rate is unusually low, then an asset’s price will become correspondingly sensitive to information about dividends or risk premiums in the distant future.”

Implications of volatility for fixed income investors

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All else equal, the lower the bond coupon, the higher its duration. In particular, Long-term bonds have larger durations compared to short-term bonds. The higher the bond’s duration, the higher its sensitivity to movements in interest rates. For example, the iShares 7–10 year Treasury Bond Fund (IEF) with an average effective duration of 7.56 years and an average coupon rate of 2.14% has higher interest rate risk than the Vanguard Intermediate Term Treasury Bond Fund (VGIT) with an average effective duration of 5.17 years and an average weighted coupon rate of 2.47%. However, average maturity for IEF at 8.55 years is also higher than VGIT at 5.5 years which also impacts the fund durations.

High merger activity

Higher merger activity is another outcome of low real rates of interest. A merger can result in significant upfront costs including the costs involved in identifying an appropriate merger target and the one-time reorganization costs undertaken in order to realize the benefits of merger synergies. According to Dr. Kocherlakota, “Businesses will be more willing to pay the upfront costs of a merger in exchange for the anticipated flow of future benefits associated with the merger if the real interest rate is low.”

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Companies in the S&P 500 Index (VOO) have been on an M&A spree due to the prevalence of low real rates of interest over the past few years. An example of merger activity is the acquisition of Sprint (S) by Japanese telecom operator, SoftBank in July, 2013, which was financed mostly through debt. Besides Sprint, Softbank has made it clear it wants to acquire T-Mobile as well—another major U.S. telecom player. If the latter deal receives the go-ahead from regulators, it is would probably be debt funded, like Softbank’s other acquisitions. To learn about these deals in greater detail, please read the Market Realist series, The latest word in telecom: Can SoftBank swing a T-Mobile deal?

Dr. Kocherlakota further explained that the three outcomes mentioned above, are also associated with signs of financial instability. In the next section, we’ll discuss his views on how low real interest rates affect financial stability and how the Federal Open Market Committee (or FOMC) may only be able to achieve “its congressionally mandated objectives by following policies that may result in signs of financial market instability.” Please continue reading the next section of this series.

 

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