Higher interest rates are unlikely to cause a major systemic risk but anxious investors should be wary of the continued AI-fuelled exuberance in the US stock market.
In a note published yesterday, Paul Dales, chief UK economist at Capital Economics, said it was “too early” to be sure that higher rates would not cause further fractures in the financial system.
Nevertheless, “the chances of a systemic financial event are diminishing,” he argued.
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Interest rates were near zero for over a decade following the financial crisis as global policymakers tried to inject some life into the economy. Many economists argued that ultra low rates facilitated excessive risk-taking in financial markets which would be exposed when interest rates rose.
Although there have been pockets of instability, including the LDI crisis in the UK and the collapse of Silicon Valley Bank, there have not been any systemic issues.
“It appears that policymakers have managed this transition to a higher interest rate era well,” Dales said.
On the whole, economists reckon that rates won’t go back to their post-financial crisis lows. Dales argued that this would be a positive for financial stability since investors would not be incentivised to undertake a ‘search for yield’.
Low rates effectively tempt investors to take gambles to try and make larger returns. Higher rates, in contrast, should prevent large imbalances from building up in areas dependent on credit, such as housing.
However, Dales suggested the impact of higher interest rates would be less effective in tempering “speculative behaviour” elsewhere.
“A prime suspect could be the current wave of enthusiasm for Artificial Intelligence,” he said.
Dales suggested that a “bubble” might be forming in the US equity market, driven by the “wave of enthusiasm” for AI.
The tech-heavy Nasdaq index jumped around 45 per cent last year, led by the ‘Magnificent Seven’ tech stocks. The S&P 500 also notched a 25 per cent gain over 2023.
“The next big financial event may be more like the dotcom equity crash in the early 2000s than the housing crash/Global Financial Crisis (GFC) in the late 2000s,” he said.
Dales’ warning echoes concerns raised by Jonathan Hall, an external member of the Bank of England’s Financial Policy Committee.
Hall said that “exuberance” was one of the biggest risks facing the financial system. “If conditions seem calm, if volatility is low, then you could get a risk of exuberance — people taking on more risk because they think the market is more benign,” he said.