Warning – Interest rates rising
As we near the beginning of the end for Quantitative Easing, interest rates are rising sharply in indebted developing nations. QE was only ever going to give powerful nations a short term trade advantage by lowering their exchange rates, and asset bubbles were an inseparable consequence of low interest rates. Now the storm clouds are gathering for the end of our golden run.
Since around March 2015, the price of risk has been adjusting around the world. Returns on long term government bonds (debt) have risen by around 1 percent in developed nations and more than 1.5 percent in many developing nations. Volatility in currency and interest markets has also increased, which may signal a major adjustment ahead.
This brings back memories of 1997/98 when falling commodity prices, especially oil, a stronger US dollar, rising US interest rates, emerging market debt and weaknesses led to the Asian financial crisis. Falling commodity prices, weak domestic demand and inflated asset markets add to the pressures.
Plus I have a nagging feeling that with such extreme levels of wealth in today’s world, when the downside hits we might face a far more rapid withdrawal of investment capital than ever before, as the super-rich pull their money out and sit back in luxury. With no liquidity, the price of debt and therefore interest rates might rise rapidly.
I don’t think another global crisis is imminent yet – governments are resilient and there’ll be more “whatever it takes” subsidies for business, more transfer of risk and debts to government still to come, but it’s getting closer. Close enough that we sold our overpriced mortgaged home to replace debt with cash…
For further background, read on: abbreviated from two articles by Satyajit Das on www.economonitor.com
Interest rate policy uncertainties:
Since Lehman Brothers left the mortal coil, central banks have injected over US$12 trillion under QE (Quantitative Easing) programs into money markets. These policies, according to policy makers, have been crucial to the ‘recovery’. Financial market valuations have increased but remain reliant on low rates and abundant liquidity. The effect on the real economy is less clear.
Now there is increasing confusion about future interest rate policy. For the last 12 months, US Fed Chairman Janet Yellen has prevaricated about increasing interest rates. Puzzlingly, the fed Chairman has also hinted that more QE or negative interest rates are also possible, should conditions dictate.
The Fed has not had a rate increase for 112 months. This is the longest period ever since World War 2 with the previous longest being 49 months between May 2000 and June 2004.
Everyone else is cutting rates. In Europe, ECB President Mario Draghi has already hinted that he will consider lowering rates further soon. European central banks are already operating negative deposit rate policies. The ECB is at minus 0.20%, Swiss policy rate is minus 0.75%; Sweden’s policy rate is minus 0.35%.
In October, Italy sold two-year debt at a negative yield for the first time. Investors are now paying to lend to a country which has one of the highest debt-to-GDP ratios in the world. It is also a country synonymous with pizza, pasta, political gridlock and fiscal indiscipline.
The Bank of England has suggested that UK interest rates may not increase until 2016 or even 2017. The Bank of Japan (“BoJ”) has promised additional easing if necessary “without hesitation“. The Japanese have even rebranded QE as – QQE (Quantitative and Qualitative Easing). The Qualitative is central banks talking about easing.
The People’s Bank of China, China’s central bank, cut benchmark interest rates for the sixth time this year to a record low of 1.50% in a bid to support an economy which is forecast to grow at its slowest annual rate in 25 years. Further interest rate cuts are forecast in Australia, New Zealand and many emerging countries.
Low rates have created problems for savers and retirees around the world. Pension funds are in trouble with rising levels of unfunded liabilities. German Finance Minister Wolfgang Schaeuble has drawn attention to the increasing solvency problems of insurance companies and retirement funds in an environment of low or negative rates.
Debt levels are continuing to rise from unsustainable to even more unsustainable. Low rates have distorted financial markets and created asset price bubbles in shares, property, and other investments.
Japanese interest rates have been around zero for almost a decade. The BoJ has undertaken nine rounds of QE. The central bank balance sheet is approaching 70% of GDP. It owns a significant proportion of the outstanding stock of government bonds and equities. But the policies have not restored growth or addressed the problems of demographics or need for changes in Japan’s economic model.
The effect of further rate cuts is also diminished by continuing trade and currency wars. Each individual cut is increasingly offset by competing reductions elsewhere in the world. Despite denials by policy makers, countries are using monetary policy to devalue currencies to gain competitiveness and capture a greater share of global demand. Negative rates may increase Euro-Zone exporters’ share of global demand, but they do not increase the Euro-Zone’s contribution to global demand growth. Individual nation’s actions are now redundant in a nugatory race to the bottom in interest rates and currency values.
Maintaining interest rates at low ‘emergency’ levels for an extended period also makes it increasingly difficult to increase them to more normal levels. Increase in debt levels, made possible by lower rates, means the financial impact of higher rates is attenuated.
This is evident in the concern that a potential 0.25% increase in US rates has created. In the US, a 1% increase rates would increase US government interest costs by around US$180 billion from its present level of around US$400 billion. Unless offset by increased economic activity, it would increase the budget deficit and government debt levels. The normalisation of rates to say 2.50-3.00% may prove financially and economically destabilising.
Low rates and QE have also reduced the political appetite for needed policy changes. Lower Interest costs have sapped the willingness for fiscal reforms, debt reduction and structural reforms. Asset markets, especially equities, have rallied repeatedly on the continuation of low rates, but low rates reflect slower economic activity and economic weakness rather than strength. This means, at some stage, a dramatic reassessment of asset prices is now inevitable, either because interest rates increase or because they do not.
Central Bank Policies (Quantitative Easing)
Since 2009, the key driver of financial markets has been low rates and abundant liquidity which has boosted all asset prices. In the great reflation, according to one estimate, over 80 percent of equity prices are supported in some way by quantitative easing (“QE”).
Today, as much as US$200-250 billion in new liquidity each quarter may be needed globally to simply maintain asset prices. However, the world is entering a period of asynchronous monetary policy, with divergences between individual central banks which has the potential to destabilise asset markets
The discussion around the possible first increase in US interest rates, beginning the process of reversing the emergency zero interest rate policies implemented to combat the 2008 crisis kisses an essential point. The US Federal Reserve is scaling back, terminating purchases of government bonds and mortgage backed securities (“MBS”), which at their peak provided over US$1 trillion a year in new funds to markets. While new purchases have ceased, the Fed does not plan to sell its portfolio of around US$4 trillion of securities. It will continue to reinvest principal payments from its holdings of MBS and roll over maturing Treasury bonds.
The combination of maintaining its balance sheet at sizable levels and low official interest rates will keep financial conditions loose. But the Fed will not add significantly to liquidity. The withdrawal of Fed support will be offset, many have assumed, by the European Central Bank (“ECB”) and Bank of Japan (“BoJ”).
The ECB plans to expand its balance sheet by over US$ 1 trillion over the next 18 months, through a mixture of purchases of government bonds, asset backed securities and loans to banks. Based on its current plans, the BoJ plans to purchase Japanese government bonds at an annual rate of over US$700 billion. At 16 per cent of gross domestic product (“GDP”), the Japanese program is much larger than the corresponding US Fed’s QE measures adjusted for relative size of the two economies.
The balance sheets of the BoJ and ECB should expand by a total of a minimum of US$2.5 trillion by the end of 2016 at current exchange rates. This is comparable to the US$3.6 trillion expansion in the Fed’s balance sheet since 2008.
A wild card is the People’s Bank of China (“PBOC”) which is also loosening money supply. Initially, this appeared to be to mitigate the sharp tightening in liquidity resulting from the increasing controls on China’s shadow banking system. More recently, it has been targeted at supporting falling the stock market and slowing economic activity.
But there are differences between the liquidity programs. The US Fed and BoJ primarily purchase government bonds. The ECB also lends to banks. The PBoC acts almost exclusively through the banking system. The crucial difference between the actions of individual central banks is that the ECB, BoJ or PBOC cannot directly supply the dollars crucial to global markets.
The importance of dollar liquidity is driven by several factors. First, the US dollar remains the most important global reserve currency. Second, the US dollar plays a crucial benchmark role with a number of currencies formally or de facto linked to the dollar. Third, the largest amount of foreign currency debt, especially that issued by emerging market borrowers, is denominated in US dollars.
According to the Bank of International Settlements (“BIS”) as at the end of Q3 2014, US dollar credit to non-bank borrowers outside the US totalled US$9.2 trillion, comprising 46 percent debt securities and 54 percent bank loans. The total has increased over 50 percent since end-2009. Emerging market borrowers have borrowed US$5.7 trillion in foreign currency, comprising US$2.6 in securities and US$3.1 trillion in bank loans. Around 75 to 80 percent of this debt is estimated to be dollar denominated.
Tightening of available dollar liquidity, a rising US dollar and anticipated increases in American interest rates will result in losses on these borrowings. In turn, this will create repayment difficulties for over-indebted borrowers, in turn triggering a new financial crisis. The risk is exacerbated by domestic weaknesses in many emerging markets.
Low commodity prices compound the problems. It reduces the US dollar denominated revenue available to meet debt obligations of exporters, increasing potential exposures to currency fluctuations.
It also reduces global dollar liquidity. Since the first oil shock, petro-dollar recycling, the surplus revenues from oil exporters, has been an essential component of global capital flows providing financing, boosting asset prices and keeping interest rates low. A prolonged period of low oil prices will reduce petrodollar liquidity and may necessitate sales of foreign investments.
Emerging market foreign currency reserves are also falling, led by substantial falls in Chinese reserves due to a combination of weaker trading conditions, capital flight and (suspected) liquidation to release capital to support the domestic economy and share markets.
Declines in global liquidity driven by falling petrodollar liquidity and emerging market currency reserves affect asset prices and interest rates globally. It will increase interest costs and affect the ability of borrowers to gain access to needed dollars.
Since around March 2015, the price of risk has been adjusting around the world. Yields on 10-year German government bonds (known as Bunds) have reached above 1 percent, up from near zero a few months ago. French, Italian, and Spanish yields have also risen by similar amounts. The bellwether 10-year US Treasury yield has risen around 0.60 percent. Equivalent Australian government bond rates are up around 0.80 percent. Rates have jumped in emerging markets: 1.75 percent in Indonesia, 1.60 percent in South Africa, 1.50 percent in Turkey and 1.30 percent in Mexico.
The interest rate moves have been accompanied by large changes in currency markets. Volatility in currency and interest markets, in particular, has increased. Shares markets have been affected but not nearly as much. Like the early tremors that indicate the heightened risk of the big one, these large moves may signal a major adjustment.
The position is eerily similar to 1997/98, when falling commodity prices, especially oil, a stronger US dollar, rising US interest rates and emerging market debt and weaknesses led to the Asian monetary crisis, the Russian default and the collapse of hedge Long Term Capital Management. For the world’s many economies addicted to foreign capital, the threat of instability in international money markets is serious. This is so especially when other pressures such as the end of the commodity boom, weak domestic activity in many economies and inflated asset markets are considered. The risk to financial stability is rapidly increasing.