Interest Rates, Overvaluation of Assets, and Banking 101

I was having a chat with someone who’s really smart and they were breaking down the state of the economy for me…

At one point during the conversation, he dropped this line on me; “From 2008 to today, 0% interest rates have left everything overvalued”.

While I’m somewhat ashamed to admit this, up until that convo, at no point in my life had I ever pondered the downstream effects that zero percent interest rates might have in the world. I’ve been ignorant.

But I don’t want to continue being ignorant about interest rates any more, so I started doing some research. Today I will share my notes/breakdown of the relationship. between interest rates and the overvaluation of assets.

Why Zero Percent Interest Leads to Overvaluation:

While the relationship between Zero Percent Interest Rates and overvaluation can be complex and multi-faceted, some key reasons often include:

1. Search for yield

2. Cheap borrowing costs

3. Asset price inflation

4. Risk appetite

5. Market distortions

1. Search for Yield
When interest rates are low, traditional safe investments, like bonds, offer lower returns, so investors seek higher returns elsewhere. To generate better yields, investors often turn to riskier or speculative assets. This "search for yield" frequently drives up prices on these assets, potentially leading to overvaluation as demand surges.

For example, let’s say rates are so low that your savings account and government bonds aren’t generating high enough returns… So what do people do? They start throwing cash at tech stocks, crypto, luxury real estate - really anything, hoping it'll pay better. Before you know it, we’ve got people bidding up prices on NFTs of digital rocks. That’s the search for yield. When low-risk options give you nothing, everyone flocks to riskier stuff, driving up prices on assets that sometimes (oftentimes) aren’t worth the hype.

2. Cheap Borrowing Costs
Low interest makes borrowing cheaper, which leads to greater leverage for those borrowing money. So as individuals & businesses take advantage of favorable borrowing conditions in order to invest in assets like real estate or stocks, the increased demand for these assets can drive up prices which can lead to overvaluation.

Think of cheap borrowing costs like this: imagine you’re at a bar with a special where all drinks are on the house! Everyone’s ordering up, thinking they can have as much fun as they want. Now, picture someone deciding to take out a loan to buy a fancy bottle of champagne because, since we’re saving all the money we would have spent on drinks, why not? As more people do this, the price of champagne at the bar skyrockets because everyone wants a piece of the action. But when the free drinks promotion ends and the well runs dry, that champagne is still overpriced, and suddenly, people are stuck with bottles they can’t afford. It’s a blast while it lasts, but when the party’s over, the reality hits hard!

3. Asset Price Inflation
Low interest rates can contribute to inflation in asset prices, including stocks & real estate. Investors may be willing to pay higher prices for these assets when the cost of financing is low, which leads to overvaluation.

For example, imagine you’re in the galaxy far far away trying to become one with the force, where the Empire just slashed interest rates across the board. Suddenly, every smuggler and droid mechanic is rushing to get a loan for a new starship. Han Solo thinks, “I can finally upgrade the Millennium Falcon, let’s throw some cash at that!” As more and more people in the galaxy do this, the price of ships skyrockets. Meanwhile, the wise & powerful Yoda sits back, watching the chaos unfold, thinking, “Good luck with that overvalued hunk of junk.” But when the Empire raises rates again and the galactic economy takes a hit, those overpriced ships crash harder than a TIE fighter at the Death Star’s junkyard. Guess who’s left stranded on some desert planet, waiting for a ride? Spoiler alert: it’s the guy who thought he was getting a steal on a souped-up speeder!

4. Risk Appetite
In a low-interest environment, investors often develop a higher tolerance for risk because safer investments, like bonds, don’t provide appealing returns. This shift leads them to explore riskier assets with the hope of higher gains. As their risk appetite grows, speculative behavior increases, driving up the prices of certain assets and contributing to their overvaluation.

For example, say interest rates are so low that it’s like a green light at a racetrack… Investors are revving their engines, thinking, “Time to take some wild risks!” Suddenly, a hot new trend emerges - people are buying up vintage comic books, convinced that their value will skyrocket. It’s not just any comic book; it’s the one where Spider-Man buys Kim Kardashian’s newest eyeliner. Investors are throwing money around like crazy, completely ignoring the fact that many of these comics are just old paper with a hero on the cover. When reality hits and prices plummet, those investors are left staring at a stack of comics worth less than the cost of a used taco truck.

5. Market Distortions
Persistently low interest rates can lead to market distortions, making it challenging for investors to accurately assess the true value of assets. This environment can result in mispricing and overvaluation, as investors rely on artificially low borrowing costs rather than fundamental value.

For example, let’s say interest rates are low and investors are looking around, trying to figure out what anything is actually worth. It’s like walking into an art gallery where every piece is priced at a million dollars because, hey, who wouldn’t pay for a painting of a cat wearing sunglasses? With money flowing like it’s a bottomless well, people start buying up assets based on hype rather than actual value (thus the term ‘distortions’). Suddenly, you’ve got people shelling out big bucks for NFTs of a pixelated potato because they think it’s the next Picasso. But when the dust settles, they’re left holding a glorified digital spud that nobody wants.

Now let’s cover some common scenarios when interest rates come into play.

1. Loans

2. Mortgages

3. Credit Cards

4. Savings & Investments

5. Central Bank Rates

1. Loans
When individuals or businesses borrow money from institutions (institutions like banks, S&Ls, credit unions, investment banks, hedge funds, insurance companies, mutual funds, pension funds, peer lending platforms, etc) they typically pay interest on the amount borrowed - this applies to various types of loans including personal loans, auto loans, and business loans.

2. Mortgages
Homebuyers often take out mortgages to finance the purchase of a home. Mortgage loans come with an interest rate, and borrowers make regular payments that include both principal and interest (principal refers to the original amount borrowed, AKA not the interest).

3. Credit Cards
Credit card companies charge interest on outstanding balances. The market rate on credentials is generally higher than rates on other loans. Interest rates on credit cards are generally higher due to several factors including:

• credit card debt is unsecured

• risk profile

• short-term & revolving nature fo credit card debt

• convenience & versatility of credit cards

• fees & overhead costs

• market competition

4. Savings & investments
Interest rates also apply to savings accounts & certain types of investments. When you deposit money into a savings account or invest in fixed-income securities like bonds, you may earn interest on your principal.

5. Central Bank Rates
Central Banks set interest rates as part of monetary policies. Their interest rate, such as the Fed Funds Rate in the USA, influences the overall level of interest rates in the economy. Changes in central bank rates can impact borrowing costs throughout the financial system.

OVERVIEW: Commercial, Central, and Investment Banks

1. Commercial Banks
Functions as traditional banks that offer wide ranges of financial services to individuals, businesses, & governments. Services include savings & checking accounts, loans (including mortgages & personal loans), credit cards, and more.Customer focus is geared toward retail banking for the general public as well as corporate banking for businesses.

2. Central Banks
Functions as the primary monetary authorities in a country or group of countries. They are responsible for implementing monetary policies and regulating the money supply. Their role in the financial institution is crucial in maintaining price stability, controlling inflation, and promoting economic stability. Central banks are often the sole issuer of a nation’s currency, and they manage the nation’s reserves of foreign exchange. They are also typically independent entities to ensure that monetary policy decisions are not subject to short-term political influence (note: that could perhaps be the conventional explanation, where the real reason remains shrouded in what some might write off as conspiracy).

3. Investment Banks
Functions to facilitate creation of capital by underwriting & issuing securities, providing advisory services and engaging in various financial transactions. Services include assisting corporations & governments in raising capital via IPOs, bond insurances, etc. iNvestment activities include trading securities, managing mergers & acquisitions, and offering financial advice to clients. Client base includes primarily large corporations, institutional investors and high net worth individuals. Risk-taking: unlike commercial banks, investment banks often engage in riskier money moves.

Ok, so that was my intro into the world of interest rates and banking. I have a lot to learn.