One of the drawbacks of The Federal Reserve’s zero interest rate policies (ZIRP) and possibly negative interest rate policies (NIRP) is the problem created by ultra low interest rates. At ultra low interest rate levels, Treasury prices (as well as mortgage-backed security prices) can fall quite rapidly with increases in interest rates. This dramatic change in prices due to rising interest rates is known as CONVEXITY and The Fed (along with other central banks) has helped to create a scary scenario … if and when interest rates start to rise.
Of course, older bonds or MBS with higher coupon rate are more susceptible to convexity problems, but even current coupon bonds are exposed to interest rate increases, particularly if The Fed follows Europe’s lead with negative nominal interest rates.
Think of the trillions of dollars of Treasuries and Agency MBS held by The Federal Reserve itself, Fannie Mae, Freddie Mac, pension funds, China, Japan, and other investors.
Other than convexity risk, here is another risk created by uber-low interest rates: refinancing risk. On the one hand, falling interest rate have helped Treasury refinance their debt with progressively lower coupon debt, just as mortgage borrowers are able to refinance their mortgages at lower rate. But with rising interest rates, the opportunities for lower-interest refinancing are fewer.
Here is what has happened with Treasury debt. After the 2001 recession, Treasury began refinancing their debt over shorter maturities (and under Clinton, Treasury paid down the 30 year debt). The result was a DECLINING average maturity (and duration) of debt. That is until 2009. Since 2009, Treasury has been raising the average maturity of their debt so it is back to near 2001 levels. Of course, longer maturity debt is more risky in terms of price changes.
So, The Fed’s (and other central banks) allow their huge stockpiles of debt to be issued and refinanced a progressively lower interest rates (leading many to issue debt rather than raise taxes by the full amount to cover increase government expenditures). The drawback is massive debt loads AND the convexity trap if interest rates start rising again.
Of course, investors will try to hedge their positions if and when interest rates begin to rise. Good luck with that, particularly if we get “surprise” jumps or shocks.
To paraphrase Steve Urkel from the TV show Family Matters, “Did we do that?”