No, it is low rates that Wall Street ‘hates’

Busy week as I was on the road for business reasons, so no update over the past week.

Noah Smith published an article on Bloomberg arguing that Wall Street doesn’t hate low rates, but hates the Fed. He argues that low rates are beneficial for Wall Street, given that “lower rates mean higher asset values, at least mathematically”. Consequently, he says that the reason why Wall Street doesn’t like low rates is a ‘mystery’. He concludes that:

We may never know exactly why Wall Street hates easy monetary policy with such a violent passion.

I will argue that the only ‘mystery’ here is: why are economists so ignorant about banking and finance?

Unfortunately, and like plenty of central bankers, economists and economic commentators, Noah Smith is guilty of ignoring the margin compression phenomenon. The argument roughly follows those lines: “Why are all those bankers complaining?? Low rates are beneficial! Banks can refinance at lower rates and increase lending volume to boost their profits!” Well, no. I let you refer to my previous posts: under a certain threshold, lowering rates is actually a huge issue for banks, as loan repricing keeps pushing (gross) interest income down while interest expense cannot go down further because deposit funding (and even in certain cases wholesale funding) is stuck at the zero lower bound. Margin falls and net revenues suffer whereas fixed costs remain stable (or even increase due to regulatory and compliance requirements).

What about the buy-side? Surely they must like low rates? Well… to an extent, and more importantly, in the short run, yes. Securities reprice upwards and they make nice mark-to-market gains. Unfortunately for the theory, this is a one-off effect and the portfolio turnover process gets in the way. Fixed income investors, as their securities mature, have to replace them with lower-yielding ones. Investors mostly care about real rates. As their RoI starts trending downward and barely covers inflation, their natural reaction is to go down the rating scale to hunt for yield. This FT article highlights that subprime and leverage loans securitizations have jumped back to pre-crisis highs in the low-interest rate environment. With risk assessment suppressed, asset mispricing is widespread.

In both cases, the key isn’t low rates per se. It is interest rates that fall below a certain threshold.

I’m really wondering whether actual banking experience should become a prerequisite to become a central banker, or whether bank accounting/financial analysis courses shouldn’t be made compulsory for economists and journalists that wish to follow and comment on the banking and financial world…