This pillar is quite short, but here it goes.
As the Fed lowers interest rates, especially in an environment where I argue real growth is slowing, the value of assets increase. So, real estate, stocks, farmland, bonds. Everything goes up in value. When they increase interest rates, those prices are likely to drop, so I call this “asset deflation.” Either way, the prices of assets over the coming years are likely to be more volatile, up and down, or unpredictable in my mind.
This occurs for a few reasons, and plenty of other websites that explain this better than I do.
The main reason this happens though is the following:
- Lets say interest rates today are at 2%, and therefore you can earn 3% on a Treasury Bond or in your savings account.
- But you find a real estate investment that pays 10%
So which do you invest in? Real estate probably, assuming its not risky.
- Then interest rates drop to 0%
- You can borrow money to finance your investment for almost nothing, so you buy more real estate
- More people try to buy more real estate driving the price down. Now returns are say 5%, but 0% in your savings accounts.
- When money is cheap to borrow, people tend to leverage it, driving up prices of assets (stocks, real estate, etc…)
- Of course, the entire economy is stimulated because companies and consumeres can borrow against the future for next to nothing too.
Now, for the last step. Let’s say the Fed increases interest rates again:
- A CD, savings account, or money market fund then starts to offer 5% again
- But real estate was at 5% too.
- Which would you invest in? One requires a lot of work and risk. The other. No risk and no work.
- Now asset prices drop far enough that their returns are back to say 10% again,
- and that drop could be half of what you paid for it!
Therein is the problem, especially at the lower end in my opinion, as rates get near to 0, the leveraging effect may increase, but I haven’t proved this yet.
As interest rates go down, people may take increasingly larger risks on investments to keep achieving returns. Think of all the funds, like retirement, pension, endowment (colleges), and other money used to save for the future. How is anyone ever going to retire if they dont make for example, at least $50k/year?
The simplest solution is as returns on investments (assets) goes down, to overpay as money chases assets. For example if someone needs to make $50k/year for retirement, then for example, investing $1M in a rental property at 5% accomplishes that. Now, as interest rates, and therefore returns, goes down to say 2.5%, then now, that person needs to have $2M invested to reach that same level of income. So, while they are not able to simple raise more cash, the other likelihood is they are investing in increasingly risky assets (risky bonds and complex securities) to achieve returns, which we saw somewhat in the 2008 crisis. Today it may be over-leveraged, black box investments like private equity, and we will eventually know; for as Buffett has said: we will see who has been swimming naked when the tide goes out.
For now, it seems that making real returns on business will be overshadowed by those who know how to get in and out of asset bubbles.