Investors beware: Dangerous yields ahead

Why are interest rates so low?

And how long will they stay that way?

As the Bank of International Settlements (BIS) highlights in its annual report released this week:

“Interest rates have never been so low for so long. Between December 2014 and end-May 2015, on average around $2 trillion in global, long-term sovereign debt, much of it issued by euro area sovereigns, was trading at negative yields.

“At their trough, French, German and Swiss yields were negative out to a respective five, nine and fifteen year yields.”

The yields nominated above are unprecedented and disconcerting.

As the bank says in the report’s opening paragraph: “There is something deeply troubling when the unthinkable threatens to become the routine.”

Arguably that has already happened.

Current low yields are indicative of a much broader malaise than that which has struck Greece.

Global monetary practices need reform 

The BIS report suggests that without a major overhaul of global monetary practices the current malaise is likely to deteriorate further and could result in the impoverishment of many who have assiduously saved to finance a comfortable retirement.

Emerging market economies (EME) that have borrowed heavily in US dollar-denominated loans are seen as particularly vulnerable.

Do not take comfort if you have no direct exposure to the emerging markets because the EME’s heft in the global economy has soared since the Asian crisis, from about one third to almost half of global GDP in purchasing-power terms.

China is a case in point. At the end of 2014, it was the world’s eighth-largest borrower of the $1 trillion in cross border bank claims, double the amount outstanding just two years before. 

Greece, the first to fall 

Greece looks to be a prospective case study of the social, political and financial implications of a mismanaged monetary and financial system.

It is the contention of the BIS that the malaise that has enfeebled financial systems reflects the failure to come to grips with slower-moving financial booms and busts that leave deep and enduring scars.

This runs the risk of entrenching instability and chronic weakness. Domestic policy regimes have been too narrowly concerned with stabilising short-term output and inflation. The BIS see the domestic preoccupation of central banks with inflation as the explanation for persistently low interest rates. 

Interest rate determination 

An economy’s interest rate structure is effectively built on the short-term policy floor set by the central bank. In addition, central banks influence long term through signals about how they will set short-term rates and, increasingly, through large-scale purchases along the maturity spectrum.

Market participants set deposit and loan rates and through their portfolio choices help determine long-term market rates.

There are many factors that are addressed by the market participants as to where the longerterm rate should sit.

Not surprisingly, expectations as to what the central bank will do rank highly amongst the factors taken into account.

The BIS report describes the conventional process of the interest rate determination and then poses and answers its own question:

“Are the interest rates that prevail in the market actually equilibrium rates? Take first the shortterm rate, which central bankers set.

“When we read that central banks can have only a transitory impact on inflation-adjusted short-term rates, what is really meant is that, at some point, unless central banks set them at their ’equilibrium’ level, or sufficiently close to it, something ‘bad’ will happen.

“Exactly what that ‘bad’ outcome is will depend on one’s view of how the economy works.

“In the prevailing view – one embedded in the popular ‘savings glut’ and ‘secular stagnation’ hypothesis – the answer is that inflation will either rise or fall, possibly into deflation.

“Inflation provides the key signal and, its behavior depends on the degree of economic slack.

But slack is difficult to measure in practice. It is subordinate to inflation.”

It is the BIS contention that: “The very low interest rates that have prevailed for so long may not be the ’equilibrium’ ones, which would be conducive to sustainable and balanced global expansion.

“Rather than just reflecting the current weaknesses, low rates may in part have contributed to it by fuelling costly booms and busts.” 

The effect of booms and busts 

The BIS report points out that financial bubbles and busts tend to be both larger in scale and longer in duration that other similar episodes.

This elasticity of finance results in too much debt, too little growth and excessively low interest rates.

“In short, low rates beget lower rates,” say the BIS.

In that summary is the answer to the second question: How long will interest rates stay low?

The answer: Until we stop using inflation as the keystone of the monetary system.

But that’s really only a small part of the answer.

The fuller version goes this way: “The right response is hard to implement. The policy mix will be country-specific, but its general features are not. What is required is a triple rebalancing in national and international policy frameworks; away from illusory short-term macroeconomic fine-tuning towards medium-term strategies; away from overwhelming attention to near-term output and inflation towards a more systematic response to slower-moving financial cycles; and away from a narrow-own-house-in-order doctrine to one that recognizes the costly interplay of domestic-focused policies.

“In this rebalancing, one essential element will be to rely less on demand management policies and more on structural ones.”

The chances of even a modest degree of success in having such a reform program implemented are currently zilch. A few more crises and perhaps a Greece of two could have a galvanizing impact. After all, there was a time, now so long ago, when the US financial stability system was run on the basis of the money supply.

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Max Walsh

Contributor

Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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