Interest Rates Need to Increase

It has been a while since the Federal Reserve last raised interest rates. Last March 17, 2017 they raised the interest rates a quarter point to 1%. The Fed signaled the economy is doing better but reaffirmed that the pace of (rate hikes) will be gradual.

There are many, including myself, that cheer the rate increase and look forward to the next.

When the Federal Reserve artificially lowers interest rates to stimulate the economy, businesses undertake various capital projects that are now considered the best allocation of resources.

This works until interest rates start to rise and businesses discover that their once feasible projects are no longer and they reverse course and start to reduce capital expansion.

Low interest rates can also lure investors to invest in riskers equities and bonds and forego being compensated for the greater risk of possible loss of capital.

Risky investment returns today stems from the starting point inventors use to evaluate returns. Today, the riskless rate isn’t 4%; it’s closer to 1%. With more normal interest rates, an investor would need at least 10%-12% to invest in real estate but today would be happy with 8%.

Many investors incorrectly assume there is a positive correlation between the amount of risk and the return. High return, high risk, low return, low risk.

Lower interest rates by the Federal Reserve lowers expected return. Each investment must compete with others for capital and thus the bar for each successively riskier investment has been set lower.

Investors are falling over themselves trying to get higher returns. By investing more capital into riskier investments investors are flattening the risk line thus attracting more capital because other investors now perceive the risk to be less.

As the lower interest rate cycle continues, investors perceive risk as being limited and move out of low-yielding safe investments into riskier investments that appear to have higher returns. The old saying “I wouldn’t touch it at any price” now becomes “looks like a solid investment to me”.

Risk is incredibly important to investors. With the volatility in the market and the low interest rate environment the level of risk becomes harder and harder to recognize.