No, It Isn't Safe

You go into the bank. You want advice. An idea, some direction. Over the last four years you've gradually accepted that you can get investment ideas at the bank. Since the Bachar reform forced the banks to sell their mutual funds, the investment adviser doesn't focus entirely and automatically on pushing the bank's own shoddy stuff. He and you can actually brainstorm what's best to do with your money.

What can you offer me? you ask. I'm not much into risk, you add.

But you don't like the answer: half a percent, maybe 1%, no more. You might even hear 0%. Zero.

That's how it is, the investment adviser explains. That's the prevailing interest rate.

You ask about short-term Bank of Israel notes, called makams. What about those? Oh, those are also returning less than 1%, she says.

How about government bonds linked to the consumer price index, say, five-year ones? She shrugs. After fees you'll be left with less than 1%, and that isn't locked in, either, it's only if you hold the bond until it matures. En route expect fluctuations, she adds.

So what are your choices? Evidently, to abandon the warm embrace of safety and to leap into the colder water of higher-risk financial assets. Every novice on the market knows that.

If interest rates have zeroed, then to get returns and profits, you have to undertake risk. To venture into longer, more volatile instruments, more exotic ones. You have to diversify, winnow through the offerings to find the gems, do a thorough job of seeking - but in any case, you're taking on risk.

You wriggle. Buying risky financial instruments is - well, risky. Always. That's the nature of risky assets. Buying risky assets in an era of zero interest is even riskier. In fact, buying risky assets is sometimes as dangerous as it can get when interest rates are at zero.

When should one buy risky assets? When interest rates are high, maybe even very high, and you expect they'll be falling.

By now we all know how the credit bubble was formed and grew, leading to a colossal financial crisis that wracked world markets throughout the last year. But what created that unprecedented boom that lasted through most of the preceding two decades?

Some say it was the high-tech revolution. Others think it was a revolution in management, or leverage, or productivity, or globalization. Very nice stories, one and all.

I have another story for you, a point for thought, in case the low level of interest rates has been firing your imagination.

The main driver behind the tremendous increase in share prices during the 1980s and 1990s was a giant wave of U.S. interest rate cuts, of all types, from peak levels in the late 1970s and the early 1980s. That was the period when Paul Volcker, chief of the U.S. Federal Reserve Board (predating Alan Greenspan), was fighting inflation.

If you've ever taken Finance 101, you know that the value of an asset, be it a stock or a house, is relative to the cost of capitalization, meaning interest rates.

When interest rates are dropping dramatically, from 10% a year to less than 1%, the impact on high-risk assets such as shares is tremendous.

Volcker did tame inflation. His successor, Greenspan, could therefore afford to sharply lower American interest rates during the 1990s, which naturally had a ripple effect throughout the rest of the world. Even long-term interest rates on U.S. bonds dropped. The upshot was surging share prices.

Then, in the early 2000s came the dot-com crash. Stocks fell hard. Osama bin Laden blew up the Twin Towers in New York and the U.S. economy ground to a halt.

At the time, not a few conservative pundits proclaimed a "lost decade" for stocks, as did we. Interest rates couldn't drop from 10% to 1% anymore - they weren't that high to begin with. That terrific driver had been used up, so we figured stocks were fated to dither at best. Maybe inch up a bit, no more.

Yet along came Greenspan and whipped out his monetary machinery yet again, cutting interest rates to nearly zero. His friend George Bush acted on the fiscal side, jacking up spending and building up terrific budget deficits, which in turn acted to inflate America's trade deficits.

That violent medicine worked wonderfully. Stock markets soared. Soared? Roared. How could stocks roar, if interest rates were low throughout that period? There was no interest rate cut to drive the gains.

They roared because this time the driver wasn't an interest rate cut, it was leverage, maddened, unthinking borrowing by companies and households alike.

They took credit directly and indirectly, some cleverly packaged to look like something else. Credit through derivatives and hedge funds and convoluted financial instruments based on mortgages, insurance contracts on bonds and options on insurance contracts, all of which relied on rising property values as underlying assets, which in turn helped inflate the credit market and private consumption even more.

The system seemed to work beautifully, at least until a year ago. Low interest rates, low property prices, globalization, consumption fueled by credit and an insane trade deficit with China enabled American share prices to rise and rise and rise. A true golden age for investments.

Then it all came tumbling down.

It turned out that a capital market built on a bubble of credit couldn't flourish forever. The global financial system almost collapsed as the worst crisis since the 1930s took hold.

Yet presto! Here we go again. For the last three months share prices have been galloping upward. Pundits who predicted a long period of gradually contracting leverage had it wrong.

What's the deal this time? Interest rates are still low, very low. What's driving the stocks? What rabbit do the world's central banks have lurking in their hats now?

The rabbit is called "quantitative easing." The central banks aren't settling for lowering interest rates to zero, they're pouring trillions of dollars directly into the market, by buying bonds and in other weird ways.

So interest rates are at zero, trillions are being spent, the stock markets are roaring again and there you are at the bank, asking the investment adviser what to do with your money.

Here is the answer.

Low interest rates are a bad investments adviser.

Most of the best investors around the world made their millions not gradually over time, but by avoiding heavy losses. If you think that low interest rates will foster a protracted boom in the stock markets, you haven't been doing your homework. If you're buying shares just because of the low interest rates, which render bank deposits unprofitable, then you'd better hope you'll get messages from above when it's time to get out of the market, when interest rates start to rise again, or when inflation breaks out.

Most investors don't get messages from above. Therefore, taking risks just because interest rates are low is a very poor way of investing. Hopefully the institutional investors managing our money have learned the lessons of the last year, and are picking bonds and stocks for us very carefully, not just buying what comes to hand because interest rates are low.