Tuesday, September 1, 2020

The Link Between Low Rates And A Vibrant Economy

While many investors talk about the link between low-interest rates driving the economy and markets ever higher they seem to forget this correlation is very weak. We only need to look at Japan to understand low-interest rates do not guarantee a booming economy. While there is a big difference between 10% and 5% interest the difference a quarter of a percent drop when you get down near zero should have little bearing on the overall economy unless you are talking about huge sums of "speculative" money. At some point, it becomes clear this is more about liquidity and the availability of money than simply interest rates. In theory, if the interest rate is low because growth is low, then the valuations should reflect this reality.

Debt Has Grown Faster Than The GDP
Low-interest rates tend to pull spending forward but there is a limit as to how far this can go. All this of course has extended into increasing inequality. Because it is clear that all people and businesses do not benefit equally from these policies, the case can be made the Fed is fueling inequality. The Fed is throwing free money at the big boys but small businesses are seeing lending standards rising, this is making getting a loan almost impossible. This will not only lead to more inequality but more zombie companies at the same time many productive small companies are forced to close their doors forever.

For years many economists claimed that only by letting its zombie banks and industries fail could Japan clean out the system and move forward. Instead, the Government of Japan ran huge deficits and ran up massive debt. The country languished in what has become known as "the lost decades" during which it avoided disaster only by the fact that it enjoyed a large trade surplus. While they claim otherwise, in many ways the Fed has put America and the world on a path that mirrors the same unsuccessful path taken by Japan. A path that avoids real reform and bails out the very people that caused many of our problems.

This also adds a great deal of risk to the financial sector. Low rates are also supposed to encourage business borrowing and boost employment, but often it also encourages savers to take on more risk than they should when they search for higher yields. History shows that when rates are held at an artificially low level for too long capital is often misallocated and flows into speculative investments. I agree with those that think inflation will spike at some point and interest rates will do the same to reflect the reality of the "risk of loaning" money. When rates do eventually rise we will most likely see a painful unwinding of these investments.

Many trading houses are busy raising price targets across the board and in a big way. After a huge spring sell-off due to covid-19, we have witnessed a massive move upward based on central bank intervention and a "the trend is your friend" attitude. Those long in this market have been overtaken with greed and seem unable to think in terms of taking a profit. Currently, the fear of missing out has created a full "risk-on" mentality that has washed away common sense.

Another factor playing into the idea of never raising interest rates is the issue of inflation, while central bankers claim inflation appears tame and is not showing up in a big way the seeds have been planted, and the number of them is somewhat shocking. Inflation lurks beneath the surface and is hidden away in the dark corners of our future. The current low-rates combined with our massive government deficit is creating a false economy that is also baking in a higher overall cost structure. Want to know where the real cost of things is going, just look at the replacement cost from recent storms and natural disasters.

The policy of rapid credit expansion while an interesting concept often brings with it negative consequences. Currently, it is being put to the test as new problems emerge in China where we saw the amount of GDP growth generated by each infusion of money decrease over the last four years. Currently, both Japan and Europe both have exceptionally low-interest rates, mirroring the U.S., but neither are witnessing stock market valuations at nosebleed-inducing levels. In fact, it is only the buying of ETFs by the BOJ that has helped move the Japanese market higher.

It is difficult to deny that savers are suffering from these low-interest rates. The leading edge of the massive Boomer generation knows that every dollar spent is a dollar it cannot re-earn or replenish. Lower rates in effect have caused many older Americans to hoard their wealth. When people cannot fund their own retirement we all suffer. Not long ago the relationship between savings and how you would live after you retired mattered. By working hard and saving a person could look forward to living well on the interest their saving earned but not today. Interestingly, on the flip-side, many people with little savings have rushed out to buy cars and expensive items they really can't afford and pulled consumption forward.

The legacy of Central Banks pursuing this "low rate" solution will be more problems down the road. By not demanding the right kind of growth and simply throwing money at problems we have delayed and are adding to a much larger crisis lurking in the future. Many of those already concerned about the strength of the economy find little comfort in the argument that conditions remain too fragile to begin a return to historic norms. It is difficult to envision how the world will handle the additional debt of governments when rates begin to rise. Over time the policy of ZIRP or NIRP is likely to prove a big mistake.

1 comment:

  1. I can no longer distinguish the actions of the fed and central banks from those entitled idiots that formed the billionaire boys club.