O.T. - WSJ thing on low interest rates and their (sometimes) effects disrupting rational asset prices.
December 14, 1998
The Outlook
NEW YORK
Low interest rates have worked magic on the markets. The crippling
bond-market freeze has thawed somewhat, and stocks have recovered most of
their losses.
But before celebrating, it's worth considering the part lower interest rates may
have played in the excesses that led to the summer turmoil in the bond market
in the first place -- and the risk that low interest rates may do something
similar to the stock market.
Why? Quite simply because falling interest rates prompt investors to
search for better returns elsewhere. Often that leads them to take on
more risk, and to price that risk too low.
That's what happened earlier this year when yields on U.S. Treasurys slipped
below 6%, reaching their lowest level since the early 1970s. At the time,
investors rolling over a Treasury bond purchased in 1988 with a coupon of 9%
were forced to lower their expectations.
Yields really hadn't fallen very much if you take inflation into account. For
example, after adjusting for an inflation rate of about 4.5% in 1988, that 9%
Treasury coupon amounted to a real yield of about 4.5%. With inflation falling
to 1.5% earlier this year, a 6% coupon on a Treasury bond still carried a real
yield of about 4.5%.
But low inflation or not, investors still had high expectations for their returns.
Some began reaching for higher yields, and in their quest, they started adding
"more exotic types of things" to their holdings, like junk bonds and
emerging-market securities, says Tony Smith, a bond analyst at Donaldson,
Lufkin & Jenrette Securities Corp. Russia, for example, sold bonds with yields
of about 9.4%; average yields on junk bonds were about 9%, according to
Merrill Lynch & Co.
But as more investors pursued the same strategy, it drove down the rates
offered by such risky investments. By earlier this year, the gap between
junk-bond and Treasury-bond yields had shrunk to below three percentage
points, or close to record lows. "People had gotten completely out of hand
with the pricing of risk," says Max Bublitz, chief executive officer of Conseco
Capital Management.
When investors repriced risk, they did so with a vengeance. In the
sell-off triggered by Russia's effective default in August, the gap
between the yields of junk bonds and Treasury bonds exploded to about
six percentage points. It has since narrowed somewhat.
This is not the first time that low interest rates preceded excessive risk taking.
The Bank Credit Analyst, a Montreal-based financial-forecast journal, drawing
on historians' observations, says that "most periods of financial euphoria began
with exceptionally easy money that triggered a speculative search for greater
return."
For example, when the Federal Reserve pushed the federal funds rate to 3%
between 1992 and 1994, the move was aimed at keeping the banking system
solvent. But it also enabled Mexico to sell billions of dollars of "tesobonos,"
which were short-term debt securities that were linked to the dollar and had
yields between 4% and 7%.
Foreign investors saw them as a substitute for U.S. Treasury bills, only
"slightly out the risk curve," says Lawrence Goodman, chief economist at
Santander Investment Securities. "The miscalculation was just how much out
the risk curve they were."
Mexico's peso-devaluation crisis shocked tesobono holders, sending their
yields as high as 25% and forcing Mexico to stop issuing them.
And the roots of Japan's stock-market and real-estate bubble in the 1980s was
the Bank of Japan's decision to cut interest rates in half as a way of offsetting
the impact of the stronger yen on its economy. Eventually, the stock-market
bubble took on a life of its own as rising prices begat higher prices. It took a
steady series of interest-rate increases by the central bank to prick that bubble.
Mr. Bublitz maintains that it will be years, if ever, before investors ever price
risk as cheaply as they did earlier this year, at least in the bond world.
Investors "have a corporate memory about those types of things."
But risk taking appears alive and well in the stock market, as indicated
by the return to record levels of various stock-market gauges and the
buoyant prices of speculative Internet stocks in recent weeks. Interest
rates have been a crucial part of the rise in stock prices.
"How often do you hear the phrase, 'There's nowhere else to put your money?'
" asks Martin Barnes, managing editor of the Bank Credit Analyst, noting that
the 4.5% offered on money-market funds looks unacceptable to investors
compared with the double-digit returns offered by stocks for the past 16 years.
But there may be a risk that individual investors take that argument too far.
Treasury-bond yields, as the "risk free" interest rate, set the benchmark for all
other investments. Thus, today's lower interest rates imply that future returns
from stocks are also likely to be modest -- in the upper single digits. Today's
high price-earnings ratios imply that each dollar invested in stocks is buying a
more modest stream of earnings in the future.
Yet, despite the efforts of money managers and Wall Street professionals to
lower their expectations, a September poll by PaineWebber and Gallup found
the average annual return individual investors expect from stocks over the next
10 years is 16%. And with even skeptical professionals unwilling to "fight the
Fed," the latest round of interest-rate cuts has only made the case for stocks
seem even more compelling. Eventually, profit disappointments or higher
interest rates are likely to bring the bull market to an end. At that point,
individual investors will discover if they really have a strong enough stomach
for risk.
Greg Ip
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