One of the strangest phenomenon for many people was watching various asset prices break new records while the world grappled with a global pandemic. How on earth could these assets be worth more now, than they were in 2019, given the economic carnage we suffered in 2020?
While there are many different reasons for this, and I do not claim this is the only reason, interest rates are surely to blame.
You see, when the economy stalls, governments around the world slash their interest rates in an attempt to get their citizens and businesses to borrow more money to either invest or spend. Let’s look at an example:
If you owned a local restaurant and you were looking to purchase new tables and chairs for your restaurant, maybe you could only get a loan at 9% to finance this. When you sit down and do the math, borrowing the money at 9% doesn’t end up being a profitable option for you as the expected increase in customer spending doesn’t offset the 9% interest rate. Now, if the government comes along and slashes interest rates to stimulate the economy, maybe now you can borrow at 4%. For some people, this shift in interest rates means that what was once a risky or non profitable option, has become less risky and more profitable.
It does not mean that every situation will now become profitable, but it does mean that every situation that relies on financing, just became cheaper. This additional savings can now be spent on other projects or other consumer spending. These two forces together are supposed to help grow the economy.
Now the flipside to slashing interest rates is typically it means the currency of your country will become less valuable. This is due to it being less favourable for foreign investors to put money into your banking system. Let’s look at an example:
Let’s say savings rates in Canadian banks are currently 5% and the Canadian dollar and American dollar are at parity. If American interest rates are currently at 4%, American investors realize they can actually borrow at 4% in the USA and put their money into the banking system in Canada to get 5%. Now if the Canadian government lowers interest rates, it means the foreign investors get paid less to have their money in Canada. This results in them selling their Canadian investments and pulling their money out of Canada, which causes the value of the Canadian dollar to decline.
Now what we’ve seen happen since the 2008/2009 recession, and really exacerbated in 2020, is what happens when all of the major developed nations cut their interest rates at the same time?
If the US interest rates fall, it should cause the US dollar to fall relative to other world currencies. However if all the major developed nations drop their interest rates at the same time, not everyone’s currency can depreciate at the same time. Since the currencies don’t depreciate against each other anymore, what happens?
Asset price increases happens. You see, if you look at the Canadian housing market and assume that a house at the start of 2020 was worth $500,000 Canadian. At the end of 2020 that same house is worth $600,000 Canadian. It is not that the house itself got 20% more valuable. It is rather that the Canadian dollar got 20% weaker.
So how do we differentiate between asset prices increasing because they are more valuable, or currencies depreciating relative to asset prices? Well, when nearly every single asset price increases, during an economic recession, they all have one thing in common. The currency that is being used to value them has decreased in relative value.
When governments around the globe increase their money supply, decrease their interest rates and depreciate their currencies, global asset prices soar. This is what so many investors missed on out in 2020, and why those investors who rushed to cash got hammered. While it may seem like cash doesn’t lose value, when you compare its value to all the assets in the economy, you have lost substantially.