By Willy Staley  Thu Apr 26, 2012

Low Interest Rates: A Ticking Time Bomb?

It’s hard to know where to park your savings these days with the market so volatile and interest rates so low. Put it in the markets and you might lose it all; put it in a savings account and you know you’ll lose it to an inflation rate that’s higher than any available APY. Buy a house? Yeah right. Naturally, this leads to a little bellyaching by consumers about the Fed’s zero interest rate policy (ZIRP) for the fact that it’s hurting America’s savers while doing little to help the economy as a whole. This is true, but it’s worth considering the downside to raising interest rates just to give your 36-month CD a better rate: it could be disastrous to the economy.

On Naked Capitalism, Yves Smith recently wrote a post explaining how ZIRP is a “hidden bank time bomb,” because of the unanticipated effects it has on where banks put their money in a low rate environment. Because ZIRP has failed to make banks actually refinance Americans’ mortgages, like it was supposed to, it has forced banks to figure out what the hell to do with all their liquid capital (much like you). So in an effort to increase their thin yields, banks have poured money into low-yielding low-risk bonds. Everyone has. Herein lies the risk of ZIRP.

Because banks have been dumping money into these bonds, they face serious downside risk in the future should the Fed raise rates, and there’s no way to hedge against it. A bond’s interest payment — called the coupon — is pegged to market interest rates at the time bond is issued and remains there until the principal is paid back and the debt is cleared. So, with banks putting their capital into long-term low-yield bonds, they’ll either be stuck with anemic cash payments long into the future while they wait for the principal payment, or stuck having to sell bonds with seriously diminished value, because the market interest rates will have been raised.

This “time bomb” Smith argues, will be set off by increasing the federal funds rate:

Now banks may be able to cover some of this us for a while. They may be able to put these low-yielding assets in a hold to maturity book…which will spare them taking mark to market losses. But they’ll still lose money on an ongoing basis if they have assets that yield 3% that they are funding at 5%.

So whenever the Fed does choose to raise interest rates — they’re saying ZIRP will continue until 2014 — there could be a bit of a blowup in the banking sector, which, as we know, tends to lead to recessions. This sequence of events has happened three times in the last three decades in the United States, argues Smith. There’s no good reason to suspect it won’t happen again. Therefore, asking for higher interest rates from your savings account is rather selfish. You aren’t, after all, entitled to low-risk investment vehicles just because you really badly want one. Banks don’t have one, and this is precisely the problem.

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