authored by

John Kierans
March 2019

Interest rates markets are the engine room of capital markets. The interest rate at which savers will lend capital to borrowers is perhaps the single most important ‘price’ in any economy.  It is the keystone of an economy.

This series of commentaries were first written in 2014.  I have updated and refreshed the commentaries with up to date charts etc.

In theory interest rates are negotiated prices.  It is the price of lending/ borrowing.  The price of money is a key determinant in almost all economic activity.  The vast majority of individuals and corporations in the economy are either net long of capital or net short of capital.   In other  words  virtually  all  players  in  our  economy  are directly or indirectly affected by the prevailing interest rate on our net savings and borrowings.    Whether we are aware of it or not, almost all significant spending, saving, investing or borrowing decisions that we make are affected by interest rates.

Scarcity of Capital

Interest rates should tell us something about the amount of savings that are readily available for lending and the demand for these saving.  High interest rates would tell us that the amount of capital available for potential borrowers is low and vice versa. This no longer happens.   Central Banks are creating credit in place of savings.  They have created trillions of dollars of new money and lent them into the system.  How can we know anything about the general supply of capital available for borrowers today?  It is important to understand I am not commenting on the ability of a borrower to get capital.  The point is that the amount of capital presently available is unlimited and no longer scarce.  As a consequence the value of real savings is diminished.  Real savings are forced to compete with central bank credit for lending opportunities.


Another important factor that must be considered when negotiating interest rates is the riskiness of the individual proposition.  In other words all other things being equal, will the lender be repaid?     This question has been rephrased today in the case of government debt and the debt of too-big-to-fail private institutions.  Today the question might be - will the borrower continue to have access to liquidity in order to rollover his debts?

Ask yourself this question.  Would you lend €1m of your capital to a going concern for 1 year knowing that the only way for you to get your money back was if the going concern will be able to borrow €1m from elsewhere next year?  If the answer is no then you might not get a job as a pension fund manager or a bond fund manager.

Literally trillions of euros of private sector money has been lent to governments worldwide on the basis that these governments will have continuing access to capital via bond markets, in other words on the basis that they will be able to borrow from somebody else next  year.  Traditionally lenders consider deals on the basis of the borrower being able to repay from his own resources.  Today, money managers in capital markets lend on the basis of the borrower being able to repay by sourcing funds from a new lender in the future.  The ability of sovereign borrowers to rollover their debt is the primary consideration.  Government bonds in developed countries have been trading at ‘bubble prices’ for years.  As Andy Haldane, the Bank of England Director of Financial stability said -“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history.”

In summary, available capital is now infinite via the printing press and ability to repay is no longer a serious consideration for sovereign borrowers.  Ergo interest rates are no longer functioning as market signals with regard to the scarcity of capital or the riskiness of investments.

The Risk Free Rate of Return

There is a further, and I would suggest even more important, consideration with regard to interest rates.  The ‘risk free rate of return’ (“ROR”) is an integral component of most financial models and calculations.  What exactly the ROR is and how it is measured is subject to some arcane debates amongst economists.  However the simplest explanation is probably the best.  It is the benefit of doing nothing with your money or put another way the opportunity cost of doing something with your money.  Will I leave my money in the bank ‘risk free’ and collect the interest or will I under write that man’s car insurance, or that lady’s life assurance or do a multitude of other things with my money?

The three month London Inter-Bank Offered Rate in dollars/ Euro etc. is most often used as the ROR.  The ROR is input into financial investment models and financial calculators. Therefore the mathematically-derived fair value of investment assets and financial services is directly dependent on interest rates.  Low interest rates (ROR) skew the theoretical ‘fair value’ of stocks, property and bonds higher.  Equally a low ROR lowers the price of financial services like car leases, insurance, consumer loans and mortgages etc.

Central banks have crushed the ROR down to a tiny fraction of 1%.   Retail and wholesale financial services are being sold at artificially low rates.  Our almost zero-valued ROR is elevating stock, property and bond prices.

Interest rates are not emitting the correct signals to markets or to the wider economy and this is leading to several severe distortions.  Although this may appear to be a subtle argument it is nonetheless very important.   It is difficult to over-estimate the corrosive effect this is having in our markets.   Think of the stealth and elusiveness with which cheap money oozed into the Irish economy after we adopted the euro.  It touched every aspect of Irish economic life.  Asset prices went up and retail financial service prices went down.  Irish households made countless spending and saving decisions while being buffeted by the warm and enchanting off shore breeze of easy money.  Small businesses and large businesses filled their sails with the same consistent steady winds and steadied their tiller toward expansion.   The Irish aren’t stupid or no more so than anywhere else.  We pointed at some overpriced properties from time to time.  But it was hard for anyone to imagine how widespread and pervasive the effect easy money was having on the Irish economy and the Irish psyche.

What happened in Ireland is happening throughout North America, Europe and Japan now.


The price of credit should be negotiated in the market place between the buyers (borrowers) and sellers (lenders) of credit.   In market jargon this process is called ‘price discovery’. At present the price of credit is administered by our central planners in government.  History teaches us two things about centrally planned prices.  Firstly, the more planned a price the less likely it is to be a true or fair price.  Secondly, price controls mandated by government have a zero percent chance of achieving their long-term objectives.

Average or conventional investors have no idea what their investment portfolio would look like in a world of 7% interest.  Being less inquisitive they probably don’t want to even think about it.  They don’t realize that the market for interest rates has been ‘socialized’.   Perhaps they don’t want to see themselves as government social welfare recipients.  It is an uncomfortable thought – are the asset prices in my portfolio high because the government is suppressing interest rates?  How long more can this go on for?

I will leave you with a final comment from the former ECB chief economist Jurgen Stark -

“It’s a crazy world: the big central banks are suspending the market….”

Read part II - Will The Market for Rates Re-Assert Itself?

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