Till the jug breaks
Central banks, in particular the ECB and the Fed, are increasingly concerned about the consequences of low interest rates for financial stability. Many asset classes have developed very positively in recent years and in some cases have moved significantly away from their fundamentally justified prices. Valuations have become expensive. This applies to the real estate markets, the bond markets and the stock markets.
This development should not come as a surprise, as reference has often been made to this expected scenario. Low interest rates play the most important role. Actually, they are supposed to stimulate investment and consumption. In the current cycle, however, demand for credit has remained quite weak and the expected and hoped-for effects on the real economy have failed to materialise.
On the other hand, low interest rates have led investors to take ever greater risks in their search for returns. This was supported by the hitherto justified assumption that the central banks would be ready to respond to even the smallest crisis signal. The consequences are now visible in almost all asset classes: an expensive and sometimes very expensive valuation. For the most part, this has moved far from a fundamentally justified level.
The banking systems are suffering from low interest rates, as profitability is slowly eroding. Private provision for old age is also becoming increasingly difficult, as bonds hardly yield any yield, which is likely to lead to social problems in the medium term. This limits the central banks' scope for action. The potential damage of further interest rate cuts is now greater than the potential benefit. The most important fuel for the capital markets - regular rate cuts - is thus running out. This is now becoming increasingly obvious, and central banks must begin to talk about the problem and warn of the dangers.
What now? When the realisation spreads that central banks have little room for manoeuvre, volatility on the capital markets is likely to increase. They will react more strongly to political and economic signals. In the medium term, high valuations should return to normal. This will certainly be accompanied by corrections on the financial markets. However, the equity markets are less likely to be the focus of attention for the time being. Asset classes that are traditionally confronted with lower liquidity when the first signs of a crisis appear should be affected first. These include low-rated corporate bonds and bonds from emerging markets.
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