The Problem with Zero Interest Rates

Monday, May 4th 2015, 3:12PM 1 Comment

by Andrew Hunt

Over the last 20 or so years, global interest rates and bond yields have collapsed to levels that few would have thought possible even in the late 1980s. The process started in Japan in the mid-1990s following the bursting of that country’s credit-driven Bubble Economy, but from 2003 – and certainly from 2008 onwards – the UK, US and much of the “dollar bloc” have followed suit. Late last year, much of Europe joined the “party” and today rumours abound that China will be obliged to join the QE/near-Zero Interest Rate club. Unfortunately, we suspect that such a fate will shortly befall China. The latest economic data has been notably soft and the banking system looks to be in a relatively poor state of health. It seems that Australasia therefore is not about to gain a benefit from a resurgent Chinese economy in the near term and it is far from certain to us that lower interest rates, if and when they do arrive, will do much to revive growth in China even in the medium term.

Unfortunately, as much of the world’s most recent GDP data has shown and our own more forward-looking indicators of global economic activity are continuing to suggest, there are few signs that ultra-low interest rate policies either have worked in the past (look at Japan’s long slump for evidence of this) or that they will work in the future. Below, we show our notionally forward-looking index of global industrial confidence, the message from which is all too clear. Even after years of ultra-low rates and QEPs, global activity seems to be continuing to lose momentum in aggregate. The global “GDP balloon” is shrinking and, while individual countries and regions from time to time can “show” periods of better growth, this is usually at the expense of some other region and the result of a competitive devaluation (for example, Europe versus the US over the last three to six months).

In theory, zero interest rates should make the price of borrowing cheaper and the opportunity cost of spending money lower (by reducing the implied return to saving) and this was supposed to, in theory, provide a boost to consumer spending and even investment. In practice, though, the zero rate regime can run into a few difficulties.

At zero or negative interest rates, we find that banks and financial institutions have little incentive to take risk and to actually supply credit to those that might wish to borrow. It is therefore of no coincidence that when Switzerland moved to zero/negative yields, bank lending effectively ceased and as a now-retired Bank of Japan official once quipped “the world told us to go to zero interest rates but when we did the bankers stayed in bed”. He was right and we suspect that European bankers will soon adopt a similar strategy. In fact, there are signs that this is already occurring.

Unfortunately, there is also evidence that, far from encouraging people to spend, ultra-low interest rates will encourage particularly ageing populations to attempt to save more of their current incomes. As the baby-boom generations have aged, they have began to look increasingly at their financial needs in retirement and the recent collapse in yields, far from encouraging them to save less, has encouraged them to save more of their incomes so that they can at least attempt to “hit” their retirement income requirements. Hence, in Japan, Europe and even now the US, we have witnessed a tendency for people to save more while spending relatively less and this is tending to depress realised rates of economic growth. Interestingly, a similar event occurred in many countries during the low real yield period in the 1970s – disappointing real returns made people want to save harder and we are at a loss to understand why central bankers have not remembered this…

The standard riposte to this suggestion is that lower yields will tend to raise asset prices and that the resulting wealth effect should provide a stimulus to growth that offsets the income problem that we describe above. Certainly, even we do believe that collapsing bond yields can create substantial rallies in risk asset prices, at least in the short term.

Within my son’s under-nine rugby team, there are a number of players – as we suspect that there is the world over – who, in their desperation to score the winning try personally, not only won’t pass the ball but will tend to run backwards when they have the ball in an attempt not to be tackled. When they run back towards their own “try line” they inevitably make much of their own team offside and the opposing team onside, a situation that normally results in the ball being turned over and the opposing team scoring. At present, we would argue that with bond yields tumbling towards zero or beyond, they are bringing most other financial markets onside and therefore notionally cheap – thereby making it easier for people to “score” in these markets.

Indeed, if we observe the relationship between bond prices and equity PERs in the US at present, we find that US equities relative to bonds have only notionally been cheaper on two occasions (2009 and 2012) in the past 50 years! This would seem to offer a “good” reason to buy shares even now.
We can suggest that equities in relation to (extraordinarily high-priced) bonds are currently not particularly expensive, even by the standards of their post-GFC range. It seems that the current level of bond prices has had the effect of putting equities onside, to use our earlier analogy, with the result that there would be further scope for a significant gain in equity prices, providing that the bond market does not sell off in the meantime.

As long as bond prices stay this elevated, former bond investors are going to have to chase other asset classes and we can see this effect occurring in real time at present. As bond yields have tumbled over recent months, they have forced insurance companies, pension funds and even households to quit bonds and to attack other asset classes, be they equities, property or exotic debt markets, with a positive impact on many prices in these markets.

Unfortunately, we are deeply suspicious that even these rising risk market values will actually create any significant “wealth effects” on spending. We have no doubt that rising property prices in the late 1980s, late 1990s and particularly during the mid-2000s exerted a very positive impact on economic growth but we would argue that this only occurred because households, companies and even financial institutions could use the extra collateral that was implicitly created by the rising property prices to gain access to more credit. In fact, in the 1980s, we worked in the economics department of a bank that championed and developed the theory of home equity withdrawal, but the latter only works if those people experiencing holding gains could realise these gains either by selling their properties and trading down the property market, or more likely by re-mortgaging them (or moving up the property ladder via the use of ever larger mortgages).

In today’s world, mortgage credit is plainly not so easily available and, in the overwhelming majority of countries that we cover, rising house prices now represent a rising cost of living that requires people to devote more of their cashflow to sustaining (for example, home equity withdrawal is negative in the US, UK, Germany and probably now much of Asia) and this by definition must be bad news for consumption trends.

In addition, we quite often hear people saying that their house is their pension. Even if these homeowners intend to trade down the property market when they retire, though, this strategy will only work if house prices are still at an elevated level when they come to sell, something that implies that there will have to be a buyer out there that is willing to pay a very high price for a house relative to their own earnings stream (since house prices in many countries are currently high relative to household earnings and goods and services prices in general; the retiring vendor needs house prices to remain at this high relative level so that the sale of the property can keep them fed and watered until their passing…). For childless couples this strategy may have some merit assuming that someone will buy their house at the price at which they need to sell but one suspects that the children of the remainder will never be able to get on the housing market ladder and therefore will need the “bank of mum and dad” for somewhat longer than the parents expected! The authorities’ creation of a semi-permanently distorted housing market may favour the ageing baby-boomers but the intra-generational conflict that such policies risk creating could ultimately become problematic.

By the same token, the enforced shift in the focus of insurance and pension funds from “income investing” into chasing capital gains will likely create more instability for the institutions themselves, less certainty of returns and even higher contribution rates for the policyholders. Funding long-term liabilities not through income but from expected holding gains looks to be the stuff of Ponzi schemes, not financial prudence, and we must always wonder just who the buyer of high-priced assets will be when the savers need to divest. Given demographic trends in much of the Northern Hemisphere, this day of “enforced” divestment is approaching. When the baby-boomers seek to cash in their life insurance/pension and other long-term savings, the historically relatively few people left in work will need to either produce a lot of income to finance their elders’ retirement or they will transfer a lot more of their own income to their older brethren.

As a result, we remain deeply sceptical that the authorities’ chosen policy mix will do much to revitalise global growth and judging by our first chart above, we may even not be sceptical enough! Far from improving, global growth still seems to be weakening. At some point, we can only assume that the world’s policymakers will realise this particular inconvenient truth and be obliged to change tack away from QE and in favour of either more fiscal stimuli or more encouragement of private sector spending. Such an event may prove traumatic for bond markets but we very much doubt that we have reached this point just yet – the authorities seem likely to persist (stubbornly) on their current tack for another three to six months at least.

In summary, we can see that there is clearly much that is wrong with the authorities’ current proffered response to the GFC and the world’s other problems of late – short term expedients are being favoured over long term solutions. It is for this reason that we continue to advocate that governments should attempt to pursue income growth through productivity growth rather than the pursuit of asset-price-gain-funded spending growth. Few in financial markets, though, have the luxury of worrying about the longer term and for the bulk of investors, QE and the like simply imply that there will be a central-bank-sponsored flow of funds out of the debt markets (that are now making everything else “onside”) and into the risk markets, which should therefore inflate under the weight of the inflows.

We therefore can expect to continue to experience the types of liquidity-driven markets that we have had over recent years. The faults and failings of the authorities’ QE and zero-rate strategies are abundantly clear – as we note above, this has not stopped asset markets in general from inflating. Moreover, as the markets inflate, the tyranny of short-term performance considerations will likely cause even the more longer-term-focussed investors to participate in the game, however reluctantly. It therefore seems to us that despite the problems in the global economy, it is quite likely that risk assets may inflate further in the near term.

Andrew Hunt International Economist London

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