"The economy is not easy to predict, but it is always easy to explain in retrospect."

Carolin Güssow, it is said that low interest rates boost the stock market. Can you explain why that is?

To illustrate this, we have to take a closer look at the process. There are many intermediate steps before low key interest rates can impact the stock market.

What is the first intermediate step?

First, we need to clarify the terminology. There is something called the interbank market. This is a market in which banks lend central banks money at a certain interest rate, which we will call the interbank interest rate. The key interest rate is now the interbank interest rate targeted by the central bank.

What options does the central bank have for influencing this interbank interest rate?

The central bank can influence the upper and lower limits of this interbank interest rate. Let's look at the lower limit first. It is important to know that banks have central bank money deposited with the central bank, known as reserves. The central bank can pay an interest rate of its own choosing on these reserves, which then sets the lower limit of the interbank interest rate. This is because it would be a loss-making transaction for banks to lend these to other banks at a lower interest rate compared to their reserves parked at the central bank.

And how can the central bank influence the upper limit of the interbank interest rate?

The central bank can also lend central bank money to the banks themselves and set the interest rate they have to pay. This interest rate then represents the upper limit of the interbank interest rate. This happens because no bank would borrow central bank money on the interbank market at an interest rate higher than that of the central bank.

And if the interbank interest rate is low, can banks also grant cheaper loans to companies, which should boost the economy?

Yes. Low interest rates should make it easier for banks to grant more credit to companies for what will hopefully be great new business ideas, thereby increasing the productivity of the economy and thus growth. This hope – that companies will get credit at a lower rate and thus be more successful in the future – is already boosting share prices.

Do you see any other effects of low key interest rates on stock markets?

There is another element to consider. The falling interest rates on the interbank market also affect other, similar financial markets. For example, a short-term government bond is to some extent comparable to a loan on the interbank market: it is short-term, i.e. it has a term of only one day to a few weeks and is considered a safe investment. Because of the lower interest rates on the interbank market, banks might now come up with the idea that they can make more profit by buying short-term government bonds instead of lending their central bank money on the interbank market. This is because the interest rate on these government bonds is not directly affected by the lower key interest rate and therefore offers a relatively higher return.

So low interest rates on the interbank market create an incentive for banks to invest in short-term government bonds?

Exactly. And when many banks follow this strategy, demand for short-term government bonds increases, which in turn increases their price. Since the price and the effective interest rate or yield on bonds are inversely related, the yield decreases as the price increases. In this way, the central bank's interest rate cut ultimately reaches the short-term government bond market.

And what does the government bond market have to do with the stock markets?

If the market for short-term government bonds has now become unattractive, other financial investors will also switch to more attractive markets. Then the price there rises and the yield falls. This process is repeated as long as there are similar markets. At some point, there are no more similar products and the interest rate level or yield has fallen for all reasonably short-term financial products. This process is referred to as the transmission mechanism of monetary policy, which triggers these portfolio shifts. As a result, all markets that resemble the interbank market become less attractive for financial investors. They then look for other investment opportunities, such as the stock market, which in turn causes their prices to rise due to increased demand.

If you look at the real economy, the outlook is rather gloomy. However, this no longer seems to play any role at all on the stock market?

We have just shown that financial markets are not very attractive for investment when interest rates are low. On the other hand, low interest rates help companies and other players to get credit cheaply and implement great investment ideas. This is boosting stock markets today because the outlook for the future should be positive with low interest rates. However, these ideas are not only financed by bank loans, but also directly on capital and financial markets. In economically gloomy times, there is much less of this new investment because the future is uncertain. And even when it does exist, investors are more cautious and prefer to flee into tangible assets such as gold and real estate, but also into equities, which are, after all, corporate participations. This causes stock market prices and other values to rise despite or because of gloomy prospects – for lack of alternatives. The stock market rally continues until reality catches up with it: layoffs, site closures... then lead to falling prices. This phenomenon is empirically known: before recessions or economic crises, asset or real values rise

Does that mean that, in your view, there is a lot to suggest a stock market bubble that could burst at any time?

I don't see a huge crash across the board, but I could be wrong. Stock markets are always good for surprises. There are also many psychological factors at play, such as herd behaviour. The economy cannot be predicted with precision, but it can always be explained well in retrospect.