With more than $7 trillion of cash starting to lose its appeal as interest rates fall, many investors will chase higher returns in riskier assets. Consumers are also expected to start spending more. At least, that's how lower rates traditionally work their way into the economy. But the loss of the interest income that's buoyed the US economy in recent years is likely to make people spend less, not more. Instead, expect much of the money leaving US savings and fixed income accounts to find its way into stocks, fueling the AI bubble -- potentially marking its peak.

I would break down the argument in four parts:

• The move out of interest-bearing products into equities following zero rates in 2008 and again during the pandemic was a stark demonstration of how lower rates buoy risk assets.
• We’re not going back to those days. Still, interest rates should have come down by two percentage points in just one and a half years through next April. That diminishes the appeal of interest-bearing assets, including cash, favoring equities.
• The risk? Households, which have come to depend on interest income again, respond to lower rates by spending less.
• The biggest appreciation in a bubble comes just before the top. With the likes of even Jeff Bezos now talking about an “AI bubble,” watch these flows as they could signal the top.

Zero-rate past is rate-cut prologue

Think about how people reacted in the months after the Great Financial Crisis. Scarred by a terrific fall in equities — 56% from peak to trough —  mom and pop investors wanted to shun the stock market entirely. But once their certificates of deposit terms expired, they had to re-invest their retirement savings, just as  interest rates cratered toward zero. Slowly at first, and more quickly as the index-investing wave I discussed a few weeks ago gathered steam, they moved into riskier assets. That’s just as policymakers wanted. 

While we’re not going back to zero rates this time, we should expect equities to benefit as interest-rate cuts continue apace. With the S&P 500 trading at all-time highs, investors have fully embraced the stock market by now. Cash will be less attractive relative to equities, high-yield debt or long-dated Treasuries.

The big risk here is that lower rates won’t necessarily spur spending, stimulating the economy just as the job market is weakening. Interest-rate cuts are thought to be stimulative by reducing borrowing costs, lowering interest expense and encouraging capital investment and debt accumulation which in turn spur consumption. That’s not how it always works.

Several years ago I wrote about over-reliance on monetary policy to do the heavy lifting of fiscal policy. A few of the main points still hold today.

In the US, for example, most American mortgage rates are fixed for the entirety of their term — typically 30 years. There is little immediate reduction in interest costs. What’s more, the costs of refinancing are so large that, it doesn’t make sense for many Americans to do so before interest rates fall substantially. 

Then there’s capital investment. As we see with artificial intelligence expenditures, firms aren’t calibrating their plans based on interest rates. Instead, as economic research published in 2013 says, “quarterly investment responds strongly to prior profits and stock returns.”  Federal Reserve research says flatly “we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases.”

That leaves households to provide the boost from lower rates — assuming that long-term interest rates, off which consumer loans are based, fall along with the Fed’s overnight target rate — which isn’t a slam dunk.

What if we spend less?

In reality, lower interest income is more likely to be felt as a loss of wealth and spending power.

For Americans, it has been a blessing to get 4 or 5% on their savings in recent years after more than a decade of earning next to nothing. This is real money in their bank accounts which they’re more likely to spend compared to paper wealth from equities. As German insurer Allianz put it early in 2023 after the pandemic stimulus began to wear off:

The wealth effect is a behavioral economic theory that suggests that asset-price fluctuations affect household spending. However, we find that the income effect overshadows the wealth effect in France, Germany, Spain and the US.

One could envisage a situation where the combination of the negative effect of losing interest income, the insensitivity of corporate investment to interest rates and a lack of mortgage re-financing, all work against propping up the economy. That would leave government deficit spending and the AI boom to pick up the slack.

All this suggests that the AI bubble might actually be at a later stage than Oaktree Capital Group co-founder Howard Marks has suggested.

I tend to think of the Fed’s rate cuts today as more akin to the 1998 ones spurred by the Long-Term Capital Management crisis. The early years of the Internet could better be characterized as a steady grind higher. It was only after LTCM was over and the US economy continued to power forward that we saw the blowoff top in shares. You can see a sort of hockey-stick style rise for the Nasdaq 100, with the step-change mania acceleration after October 1999 until we reached the peak in late March 2000.

While we haven’t seen that hockey-stick style acceleration yet in the S&P 500 or the Nasdaq, or even in the Magnificent Seven stock index, we have seen bold moves in individual share prices in large AI-centric companies like Advanced Micro Devices, Inc. Palantir Technologies Inc. and Oracle Corp. There is definitely a worrying circularity to the deals underlying the rise in shares that’s a bit reminiscent of the Internet bubble and vendor financing from the likes of Cisco, Nortel, and Lucent. And we’ve seen the hockey-stick profile in gold. That’s either a sign of central bank purchases, latent inflation concerns or extreme speculation reminiscent of blowoff tops -- or all of the above. Market action in Bitcoin also suggests animal spirits are moving investors toward riskier assets.

US equities could see a fresh wave of flows as the Fed cuts rates. The caveat is that, if these gains come too fast, they end up signaling the peak of the market.

Quote of the week

Things on my radar

• The conversion of massive amounts of office space into apartments makes me hopeful about commercial real estate. 
• On the other hand, the NYSE investing in betting firm Polymarket seems late cycle.
• The Fifth Third — Comerica tie-up has people talking of a new wave of mergers that could boost stocks.
• Federal government salaries are not game-changers for the entire US. But at the margin, this DOGE 2.0 talk is worrying, especially without back pay.
• Service sector weakness doesn’t help.

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