Low Interest Rates And Risk

The music is still playing despite global interest rates being very low. Quantitative easing is acting as an interest rate suppressant, bidding up the prices of bonds and therefore lowering yields. When you are earning almost nothing on cash and cash equivalents, anything with higher yield looks like a better bet than a bank account.

The problem with low interest rates is the risk of what will happen when they inevitably change. When we think about debt dynamics, stabilising the debt is a lot more difficult when interest rates rise. The primary surplus required if a government is running a primary deficit will be far higher than it currently is under very low interest rates.

This means that the political costs of achieving a primary surplus are almost impossible if interest rates rise, which they could given higher inflation expectations following the Bank of Japan joining in the QE party in order to keep up with the Federal Reserve and European Central Bank who are injecting enormous amounts of liquidity into the global financial system.

Each additional dollar/yen/euro at the margin is unlikely to be left earning 0% for long. But we don’t know how the QE experiment will wind down. And that means that any sudden increase in interest rates could lead to major problems for global balance sheets. If your solvency is dependent on low interest rates, and you don’t have fixed term debt, and need to constantly issue new debt to rollover old debt, then you will very quickly run into a wall.

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