2 Interesting Consequences Of Low Interest Rates

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by: Paulo Santos

The U.S. has had low interest rates for a while now, the reasoning being that lower interest rates lower the threshold necessary for someone to invest, draw money into riskier investments and relieve indebted families, companies and the State from having to pay too much interest on their debt burdens.

These consequences are more or less well established, but there are two other less frequently talked about consequences, which might also emerge in this environment.

Low Interest Rates Do Not Necessarily Stimulate Low Costs For (Small) Business Loans

It's a certainty that low interest rates, and especially quantitative easing, do produce much lower interest costs for large companies with access to the capital markets. When the Fed buys treasury bonds and MBS, the investors selling those have to replace them and corporate debt is a close substitute, so the massive money printing directly lowers interest costs for corporations able to issue debt.

However, when it comes to small businesses, the main mode for these to access financing will not be through corporate bond issuance in the capital markets. Instead, these small businesses will most often have to turn to banks to get their financing. And here, an interesting phenomenon takes place. While part of the cost of financing is connected to market interest rates, another significant part is tied to the risk of default. And the risk of default does not necessarily change much when interest rates are low. Let's say the risk of default for a given business is 5% per year with an average recovery of 50%. Right there and then making a 1-year loan would never be viable with an interest cost of less than 2.5% (never mind all the hassle and costs a default entails). So even if the market interest rate was down to 1%, the minimum a bank could charge would be a much heftier 3.5%.

So basically, by making the risk component of a loan's cost higher, more important, this limits how low the charged interest can go independently of the market interest rate. It might also disadvantage the small businesses when compared to large businesses which can issue debt in the markets, where the mechanical effects of Fed buying can take interest rates below rational levels.

Low Interest Rates Might Increase Cash Hoarding

While one of the objectives of low interest rates is to drive money into riskier investments, the opposite effect might well take place. This is somewhat visible in the huge hunger for yield one observes today, with bond funds taking in huge inflows (for instance, $40 billion during January 2013), dividend stocks being pushed up, MLPs and other yielding assets attracting huge demand, etc.

Why might the opposite effect take place? The reason is rather simple. The "stable, income producing" share of an individual's portfolio will, in a low interest environment, produce less interest. The only way to regain the income levels the individual sees as necessary, will be to hoard a much larger amount of cash and other yielding assets. $100000 at 10% interest produces $10000 per year in interest, to produce the same at 1% interest, the individual has to accumulate $1 million. This might change the perception of how much one needs to save before one can either consume or invest in riskier assets, leading to much more hoarding of cash.


Very low interest rates can produce effects which are somewhat counter-intuitive, leading to not-so-low interest costs for small businesses. Costs that are also uncompetitive with what large businesses will have access to in the same environment.

Low interest rates might also increase the hoarding of cash and low risk investments, due to the fact that to produce the same income stream, an individual has to save a lot more capital.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.