2012-04-23institutionalriskanalytics.com

One of the stranger sensations we get on a weekly basis is when we are asked how long US interest rates will remain low. The question is interesting because we all hope that the Fed keeps things as they are. An increase in interest rates pretty much implies the apocalypse, if you know what we mean, so asking about Ben Bernanke easing up on the gas pedal could be seen as a sign of economic naiveté. But leaving things as they are has a cost too.

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when Chairman Bernanke shows his naiveté by stating in public that there is no problem with the housing sector or that Fed rate policy is not causing problems for financial institutions, we have to worry. The problems with housing we think are pretty much in our collective faces, even if Chairman Bernanke and other inhabitants of Washington refuse to admit that a problem exists.

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The trouble with low interest rates is that as coupons fall, the duration on a given bond lengthens exponentially. Whereas the duration on a Fannie Mae 5 or 6 can be measured and managed using traditional interest rate risk management tools, in a low or zero rate environments the effective duration on low or no coupon securities becomes so long and so difficult to manage that hedging becomes problematic.


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