Some astute thinking is required to lift global rates out of their current malaise, but finding a solution is proving a tricky proposition.
The world is in uncharted economic territory. With interest rates bumbling along the bottom of most major economies, inflation should have taken off. Instead, the biggest threat is deflation, where prices fall over time.
Textbooks are being rewritten as central banks experiment with ways to curb saving and encourage borrowing and spending.
The Bank of Japan and its counterparts in Sweden, Denmark and Switzerland have taken the extraordinary step of thrusting their short-term interest rates into negative territory, making it more expensive to deposit money than holding it in cash. Meanwhile, the US Federal Reserve, European Central Bank and Bank of England have used quantitative easing – printing money to buy government bonds – to inject billions into the economy.
So far, only the US economy shows signs of responding as expected. By December last year, growth in the world’s largest economy had recovered to the point where US Federal Reserve chair Janet Yellen announced the first US official rate hike in more than nine years. That move, however, was controversial. Some analysts argue the Fed acted too hastily and will soon be forced to retrace its steps as US growth slows again.
“Some argue the US Fed acted too hastily and will soon be forced to retrace its steps.”
For investors, this is a wretched and confusing time. Credit has never been cheaper, but returns have rarely been worse.
Volatile sharemarkets – roiled by concerns about bank debt, plunging commodity prices and the softening growth outlook – have lost their lustre. Soaring prices, increasing credit constraints and bubble fears have made property less appealing. Even fixed-interest securities such as 10-year government bonds are not providing the returns they once did, much to the angst of major investors, including pension funds and insurers.
Meanwhile, businesses see little reason to invest while prospects remain so uncertain and are instead funnelling profits into share buy-backs and mergers.
Running short of ideas, many investors are now piling into that traditional store of value in hard times: gold, which had its strongest start to a year since the early 1980s, surging 15 per cent in the first six weeks of 2016.
The past is another country
Prior to the global financial crisis (GFC), households and businesses were buoyed by steady growth, solid labour markets and low inflation. They borrowed and spent as though those conditions would last forever. In the early post-GFC years, many investors waited for those conditions to return. It’s now clear they will not be back any time soon.
But what does the future hold in terms of replacement investment options? Theories on where to next are as varied as explanations of how we got here in the first place. The proximate cause of very low official interest rates was the breakdown of global financial markets following the collapse of Lehman Brothers in September 2008.
As international credit markets threatened to freeze, central banks stepped in by slashing interest rates, arranging currency swaps and offering term deposit facilities. Governments helped with deposit guarantees, bail-outs and cash handouts, but central banks did most of the heavy lifting in staving off financial disaster. However, some economists argue real interest rates were already on their way down well before the GFC hit.
Former Bank of England deputy governor, monetary policy, Charles Bean says a steady decline in the yield of 10-year government bonds since the mid-1990s shows today’s ultra-low interest rates have had a long genesis. He explains they were driven down as baby boomers entered middle age and intensified their saving, and as capital from China flooded the global financial system.
Lower for longer?
These theories may explain why rates got so low, but why have they stayed down and how come, in some instances, they appear likely to go even lower?
HSBC Australia chief economist Paul Bloxham points to the pressures of supply and demand. He says world output of manufactured goods and commodities has grown much faster than demand, and this oversupply is bearing down on prices.
Worryingly for investors hoping to soon see a pick-up in inflation and interest rates, Bloxham and his colleagues at HSBC expect the global economy will take years to expand enough to soak up this spare capacity and begin to put upward pressure on prices. This is the reason they expect interest rates to stay “lower for longer” and why the US Federal Reserve may be forced to unwind last December’s landmark increase.
Meanwhile, TD Securities’ Singapore-based rates strategist, Prashant Newnaha, traces the latest downturn in global growth and interest rate prospects to oil prices and the Chinese Government’s decision to devalue the renminbi last August. That move by China, which Newnaha says was driven primarily by a desire to hold the currency down to keep exports competitive, surprised markets and spooked investors, who fretted it was a sign of deeper problems in the world’s second-largest economy.
While equity markets in China stabilised – the Shanghai Composite Index soon resumed growth and doubled by the end of 2015 – the renminbi devaluation accelerated the flow of capital out of the country. At the same time, plunging oil prices prompted fears that many heavily indebted US shale gas firms were headed for bankruptcy, leaving a load of bad debts for the banks that funded them.
“Today’s ultra-low interest rates have had a long genesis.” Charles Bean, Ex Bank of England
Newnaha says these happenings have brought back the focus to a structural problem, which was highlighted by the GFC and which has never been resolved: the market’s addiction to cheap credit. Some people argue that much of the world has entered a “balance sheet recession” of the kind described by Nomura Research Institute’s Richard Koo (see breakout below).
Economists see little reason for growth, inflation or interest rates to pick up any time soon. Both the International Monetary Fund (IMF) under Christine Lagarde and the Organisation for Economic Co-operation and Development (OECD) under Angel Gurria have recently downgraded their outlooks. The IMF has trimmed 0.2 of a percentage point off its forecasts for world output and now expects it to grow by 3.4 per cent this year and 3.6 per cent in 2017. Significantly, it does not expect rich world inflation to top 1.7 per cent, leaving it below the target of the major central banks. The OECD is even more downbeat and predicts real global GDP will expand by just 3 per cent this year and 3.3 per cent in 2017.
These forecasts reinforce market expectations of continued low interest rates. That worries economists. Persistent low rates could draw yield-hungry investors to increasingly risky assets. Surging house prices already have some analysts talking of a bubble, and the conflagration on equity markets early this year has reinforced concerns of heightened asset market volatility.
The searing experience of the GFC has, in the minds of some, made the case for central banks to “lean against” asset prices. Bank of England deputy governor, markets and banking, Minouche Shafik says this should be a last resort and argues that macro-prudential tools, such as tighter lending standards and increased capital requirements, have so far been successful in containing risk.
However, Reserve Bank of India governor Raghuram Rajan believes such measures have little traction when there is a flood of cheap capital coming across the border, and he thinks central banks need to take a broader view that takes into account the spill-over effects of very low interest rates.
Australian National University macroeconomist Timo Henckel fears the world may already be heading for another GFC. He expresses concern about a world awash with cheap credit and high debt due to the central banks’ extraordinary measures to prop up growth through low-rate policies such as quantitative easing. McKinsey & Company estimates global debt reached US$199 trillion by mid-2014 – 286 per cent of world GDP, which is 17 percentage points more than when the GFC struck. Much of this debt has flowed into emerging markets and into investments linked to the commodities boom. Now that the boom has stopped and emerging market growth has slowed, borrowers face an uncomfortable reckoning.
“I cannot see there is going to be an orderly deleveraging over the next five years,” says Henckel.
“The idea that you can net things out is way too hopeful. That’s what people were saying before the GFC and we still have not netted out.”
The likelihood is that borrowers facing demands to repay will find the value of their assets under pressure, if they can find a buyer at all.
Pass the ammo
In 2008, major central banks had plenty of policy ammunition on hand to prop up activity in the asset price collapse. They will have vastly less ammo next time. Even the Reserve Bank of Australia, which has been able to hold interest rates higher than its advanced economy counterparts, will only be able to cut rates by two percentage points before reaching zero.
Although other central banks could push deeper into negative territory, it is uncertain that would achieve much. As Bank of England chief economist Andrew Haldane recently pointed out, it is not the cost of credit that has been holding back business borrowing, it has been uncertainty about demand.
Pushing official rates even lower could make things worse by increasing the squeeze on bank margins, amplifying the shock of any financial freeze. Instead, there are mounting calls for governments to stop relying on central banks and begin taking firmer action to end the global malaise.
According to the OECD’s Gurria, exceptionally low interest rates have given governments “a unique opportunity to make investments in infrastructure that will boost demand, stoke growth and actually improve public finances”. However, he warns that this needs to be paired with structural reforms such as reducing trade barriers and freeing up currency markets – politically challenging ideas at the best of times.
And these clearly are not the best of times.
Complacency to CoCo-lossal
Look closely enough into the circumstances of a financial crisis and sooner or later you will find some exotic financial instrument lurking.
In 2007, it was the little- understood collateralised debt obligations, in which mortgage-backed securities of wildly varying quality were bundled together and offloaded by the billions onto a complacent market.
This time around, a different financial innovation is causing some concern.
Known as contingent convertible bonds (CoCo), these hybrid capital securities have been created by banks as a way to help them meet stringent capital requirements.
About US$99 billion worth have been sold in the past three years. In exchange for a handsome annual return of up to 7 per cent in some cases, investors bear the risk that if a bank comes under pressure, it may convert the bond into equity or simply write it off.
The problem, says Australian National University macroeconomist Timo Henckel, is that little is known about what might trigger banks to convert CoCos, or about how liquid the market might be in a crisis.
“There are too many contingencies and uncertainties, which make it a distinct possibility that liquidity is going to dry up very quickly,” he warns.
And that is just what happened to financial markets following the Lehman Brothers collapse.
For years, Japan has been held up as a salutary lesson in what can go wrong when a property bubble bursts. Years of outlandish debt-fuelled growth ended in 1990 when Japan’s commercial property market plummeted, wiping off almost 90 per cent of its value.
Aggressive policy action, including steep interest rate cuts and massive government borrowing and spending, may well have staved off a Japanese depression as businesses and households reined in spending and investment to concentrate on paying down debt.
The problem for the Japanese economy is it has since struggled to gain any sort of momentum and has instead been locked in what Nomura Research Institute’s Richard Koo has described as a balance sheet recession.
“Nothing is worse than fiscal consolidation when a sick private sector is minimising debt.” Richard Koo, Nomura Research Institute
Koo sees evidence that the GFC has plunged other advanced economies into the same trap. As house prices tumbled in the US, Britain and Europe and financial markets seized up, households and businesses stopped borrowing, cut back on spending and focused on reducing their liabilities – just as in Japan almost two decades earlier.
In this world, where the problem was not a shortage of credit but of people willing to take out a loan, low interest rates had minimal effect. The only remedy, according to Koo, is government pump-priming.
Between 1990 and 2005, the Japanese Government borrowed and spent 460 trillion yen. Public spending on such a scale is usually criticised for “crowding out” the private sector and forcing up inflation and interest rates. But in post-bubble Japan, there was little private investment to compete with and inflation was stuck at very low levels, says Koo.
If anything, successive Japanese governments did not spend enough, and he argues that moves in 1997 and 2001 to rein in public spending were mistakes that only prolonged the recession.
Koo thinks similar moves in the US, Britain and much of Europe to cut budget deficits are ill-timed.
“Although shunning fiscal profligacy is the right approach when the private sector is healthy and maximising profits, nothing is worse than fiscal consolidation when a sick private sector is minimising debt,” he says.
“Proponents of consolidation are only looking at the growth in the fiscal deficit, while ignoring even bigger increases in private sector savings.”
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