Low Interest Rates: Steroids for the Stock Rally?

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Low interest rates are supposed to trigger economic activity and investment. Judging by rising stock and commodity markets, the strategy might be working. "Cheap money is seeking its way into the stock market," says Peter Cardillo, chief market economist at Avalon Partners.

Carry trade can end with a big shock

The worry is that the current practice is not sustainable. "Carry trades always have to be unwound," Chandler warns. By borrowing at low rates and investing at higher rates, carry traders can keep making money only as long as trends stay the same. When interest rates rise or currencies adjust, "it can burn a lot of people," he says.

"The sudden end of the carry trade [can] be a big shock wave in the financial markets," Gambera says. "It is always potentially destabilizing," he adds.

The carry trade itself is a sign of instability. Eventually, "we need to undo those extremes and go to a normal policy," Larkin says. But if rates rise too quickly, the economy could slip back into recession.

Policymakers such as Bernanke face a tricky balancing act. He consistently says markets should expect "exceptionally low levels of the federal funds rate for an extended period," as he did on Nov. 16. But to avoid putting too much pressure on the dollar, Bernanke added, in the same speech, that the Fed "will help ensure that the dollar is strong and a source of global financial stability."

Administration officials must make similar dual pledges, with Obama and Geithner trying to stimulate the economy and ease financial turmoil while also pledging to bring down the government's large long-term budget deficit.

"We need a gradual shift and not a sudden one," Larkin says.

One risk: A dollar-pumping crisis

With Bernanke reiterating his support for low interest rates, the carry trade could remain profitable for some time. But there are two big risks for those pursuing the strategy.

The first is a major crisis or international emergency that could increase the dollar's value. A year ago, when Lehman Brothers collapsed, the value of the dollar spiked as investors sought refuge in the world's most liquid currency.

Some warn that the dollar could be losing that special status, but for now there are few alternatives. Despite blows to the dollar, "there is no question that the dollar is the safe haven," says Georgetown University Finance Professor Reena Aggarwal.

The second risk is that the U.S. economy could pull out of recession quickly, prompting Bernanke to revise his endorsement of low interest rates. Market participants are closely watching economic data for such signs.

Low interest rates in Japan fueled a carry trade that lasted for years—until the play abruptly ended in the financial crisis of late 2008.

No one knows for sure whether the dollar carry trade will last for months or years. Markets are notoriously unpredictable, particularly at times of economic change. Much depends on whether the rapid appreciation of stocks and other assets this year can be backed up by real economic fundamentals. If not, talk of yet another market bubble could be justified.

Steverman is a reporter for BusinessWeek's Investing channel.

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