Low interest rate: good or bad? Why Howard Marks believes US Fed is not going back to ultra-low rates

Howard Marks of Oaktree Capital Management in his latest memo to clients said the prevailing interest rates in the US are not high in the absolute or relative to history, even if they are higher than what has been seen in last 20 years. Marks in his memo on January 9 said he considers prevailing interest rates normal or even on the low side. He noted that the fed funds rate averaged 8.2 per cent when he started his professional life in 1969. Over the next 20 years, he said, it ranged from 4 per cent to 20 per cent.

"Given this range, I certainly wouldn’t describe 5.25-5.50 per cent as high. Marks said he has many reasons for believing the US Fed not going back to ultra-low rates.

Marks said he would consider the last roughly normal period for rates was between 1990 and 2000, when the fed funds rate ranged from 3 per cent to 8 per ecnt, suggesting a median equal to today’s 5.25-5.50 per cent.

Marks said inflation in the US may tend to be higher in the near future than it was pre-2021. If true, this will, all else being equal, mean interest rates will be kept higher to prevent inflation from accelerating, he said.

Rather than be in a perpetually stimulative mode, Marks said the Fed may want to maintain the neutral rate most of the time. This rate, which is neither stimulative nor restrictive has most recently been estimated at 2.5 per cent. Having taste of inflation for the first time in decades, he said the Fed might want to encourage another bout of inflation, he said.

“These are the reasons why I believe that the base interest rate over the next several years is more likely to average 2-4% (i.e., not far from where it is now) than 0-2%. Of course, there are counterarguments. But, for me, the bottom line is that highly stimulative rates are likely not in the cards for the next several years, barring a serious recession from which we need rescuing,” Marks said.

Low interest rate good or bad?

Marks said while low interest rates stimulate an economy, it can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity.  He noted that when the interest rate is zero, there is no opportunity cost.  Besides, he said low interest rates lower the “relative bar,” making the higher returns offered on riskier assets appear relatively attractive even if they’re low in the absolute.

"The ultra-low returns on safe assets cause some investors to take additional risks to access higher returns.  Thus, these investors become what my late father-in-law called “handcuff volunteers” – they move further out on the risk curve not because they want to, but because they believe it’s the only way to achieve the returns they seek," Marks said.

Economic cycles

He described economic cycles where stimulative rate cuts first bring on easy money and positive market developments; which reduce prospective returns. This leads to willingness to bear increased risk. This, Marks said, results in unwise decisions and, eventually, investment losses.

The losses then bring on a period of fear, stringency, tight money, and economic contraction. This eventually leads to stimulative rate cuts, easy money and positive market developments!

Marks said lessons from past periods of easy money usually fall on deaf ears since they come up against ignorance of history, the dream of profit, the fear of missing out, and the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest.

These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences, he said.

"The behaviour brought on by low rates takes place in plain sight. Some people take note of it, and a subset of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And almost no one alters their investment approach to take them into account," Marks said.

Marks said when money is easy, a few people opt to sit out the dance, even though the adverse results can reasonably be anticipated. When faced with the choice between maintaining high standards and missing deals and making risky investments, most people will choose the latter.

"Professional investment managers especially may fear the consequences of idiosyncratic behaviour that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behaviour," he said.

 

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