The Problem with Zero Interest Rates

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.