A trans-Atlantic conversation on zero interest rates

After another week in which the US Federal Reserve has agonised in public over whether to start the process of raising interest rates, I thought I should hear the trans-Atlantic perspective on the issue.  So I turned to my long-time friend and former colleague at State Street, Shawn C.D. Johnson, now owner of Guidon Global LLC (see www.guidonglobal.com) but for many years chairman of SSGA’s Investment Committee, to discuss the current situation in global markets, and specifically, the implications of exceedingly low interest rates in the developed world.

 

JFN:   Shawn, another FOMC meeting has passed and interest rates in the US have once again stayed unchanged.  And despite some press talk that Yellen has put a rate rise in December “back on the table”, the markets still doubt her and the watchword still seems to be “Lower for Longer.”  What happens if interest rates in the developed markets around the world (Europe, US and Japan) stay near zero for a prolonged period of time?  What are the market impacts?  And what are the longer-term implications for capitalism more generally?

SCDJ:  Central bank policy has, for generations, been conducted principally by the administration of overnight rates.  In most capitalist countries, rates beyond the overnight rate were set by market participants.  Recently, in an effort to stimulate economic activity following the Global Financial Crisis, central banks began a process of not only setting overnight rates to zero, or near zero, but guiding rates lower across the maturities of the fixed income curve through quantitative easing.  While this helped mitigate the impacts of the Global Financial Crisis, economic growth has remained somewhat anaemic.  Now, what do central bankers do when interest rates are essentially zero or near zero across the curve, and in Europe, zero out to nearly ten years’ maturity?  All while economic growth and inflation remain subdued?

JFN:   Is there more they should do?  Should they change direction again? Indeed, what more can they do?  The interest rate channel is largely played out, and they have made very significant use of their balance sheet already.

SCDJ:  Well, there are certainly changes to the operation of monetary policy that they could make.  For example, in the US, even though the Federal Reserve has stopped quantitative easing, they are continuing to reinvest their maturing holdings, keeping their balance sheet expanded.  Likewise, they continue to pay interest on excess reserves held at the Federal Reserve.  These actions have kept US interest rates low but also discouraged banks from using their excess reserves.  They could reverse both positions – by not reinvesting maturing securities, the US fixed income market would begin to reflect the true price of credit, and by not paying interest on excess reserves, they would encourage banks to move money away from the Federal Reserve in an effort to find yield, likely resulting in more lending, or easier credit standards, or both.  Could this lead to growth or inflation?  That would likely be their hope.

JFN:   It seems to me that those two possible actions pull a little in opposite directions.  Not reinvesting the proceeds of maturing securities unwinds some of the consequences of QE, specifically the lower levels of long-term yields.  While, as you say, not paying interest on reserves (or even, as in Europe, charging banks for deposits at the central bank) will lower yields, especially at the short end.  The net effect of doing both might be to steepen the yield curve – not unhelpful for bank profitability, but not necessarily what the authorities desire.  But assume the curve stays both flat, and near zero yields out to longer maturities.  What would the impact be on debt markets more generally?

SCDJ:  If the interest rate curve is flat, borrowers would like the longest maturity possible.  With borrowed money almost free that seems to make the most sense.  We have seen corporations in the US do this.  They have borrowed money at very long tenor and bought back stock.  Would all the world’s debt markets trade more together than they already do?  Could currency volatility wane?  Or, would currency volumes fall?  After all, there is no real financial benefit from holding one currency versus another if they all yield near zero.

JFN:   Here in the UK we have seen some very long maturities for new borrowing as well – not least from the Treasury, who regularly tap the over-50-year sector of the gilt market.  And so far they have always found buyers.  But if yields are expected to be this low semi-permanently, what would lenders do?

SCDJ:  From a lender’s perspective, why would they lend any money if they aren’t receiving an adequate return?  I can certainly see a borrower wanting to borrow cheap money, but standard economic theory would suggest that lenders should not lend at uneconomic rates – unless, that is, the government requires or forces them to lend.  But then we observe that investors are already lending at negative rates in Europe.  The yield on a 5-year German bund is negative.  That makes absolutely no sense unless investors are forced to lend at that rate, or unless investors believe other investments will lose them even more money than that over the 5-year period.  And in Europe at the moment, although some investment is driven by regulatory requirements, the latter sentiment predominates.

JFN:   That is indeed a depressing thought for those with assets and funds to put to work.  But it is surely not sustainable.  As soon as markets factor in the “Lower for Longer” outlook, will they not look to put assets to work in other markets?  What about other financial markets?

SCDJ:  We have seen money flow into emerging markets if they keep their interest rates higher than those near zero in the developed markets.  And this also leads to emerging market currencies rising, because their short rates remain positive.  And indeed this makes some economic sense, since some emerging market countries’ balance sheets are in much better condition than the US, some emerging market countries have significantly less debt per GDP than the US.

JFN:   The problem with this is that confidence in emerging markets is often fragile and can evaporate very quickly, as we have seen so far this year – indeed, it is the prospect of rates rising in the US that has led to emerging markets being reassessed.  And they remain small compared to the potential flows of global money seeking a home.  So what alternatives are there?  What about real assets?

SCDJ:  Real assets, especially real estate, are heavily dependent on the availability and cost of financing.  So, with financing costs very low, we should see real estate prices hold up.  However, this relies on the availability of finance.  What happens if lenders aren’t willing to lend if they don’t make an adequate return?  Could we see the financial activity that drives real estate essentially wane?

JFN:   That is a recipe for corporate instability, especially if companies have been financing themselves short to invest long.  We are perhaps seeing some of the strains this can produce in the commodity markets, with large commodity companies looking for funding.  And natural places for them to look are pension funds and insurance companies.  How are they faring?  Will they ride to the rescue if mainstream banking pulls in its horns?

SCDJ:  Insurance companies usually write premiums that essentially keep their business roughly break even, and generally, they make money on their balance sheet investments not on their premium-writing.  What happens when the bonds they own no longer provide a yield?  Could we see insurance premium rates rise in an effort to generate earnings?  That is at least one possible outcome.  Plus, many insurance regulations require insurance companies to own bonds.  Will the regulators still require this if the bonds provide limited or no return?

JFN:   Ultimately, as you say, insurance companies can raise premiums.  But for pension funds, the equivalent is raising contribution rates, and most sponsoring companies will balk at this and many private individuals will struggle to comply.  So, assume pension funds cannot just increase their inflows from contributions and have to look to investment returns.  How will pension funds generate returns?

SCDJ:  This could be a real problem for certain countries that have mandated pension funds to invest in bonds.  Under this scenario of low interest rates, they will have no chance of generating sufficient returns to pay benefits and remain solvent.  Would we see pension funds take more and more risk, at least with the non-bond part of their portfolio?  Unfortunately, pensions may be forced to reduce benefits.  Whether different countries’ laws allow this is another question.

JFN:   We are running round the various markets and you have not yet suggested much positive news!  What are the impacts on commodities?

SCDJ:  This is somewhat of a challenging analysis.  Normally, if the cost of financing is essentially zero, commodities companies will invest, and more marginal sources will be exploited.  This is good for commodity companies generally.  But if borrowing costs are too low, supplies may rise too fast due to over-investment in commodity producing activities, and we could see commodity prices drop.  There is considerable evidence that this has happened to oil in the US  Nearly free money allowed for extensive development of US shale projects, to the extent that companies have over-borrowed.  They did this based on expected higher oil prices, and are now experiencing difficulties, while the market itself remains in heavy surplus.

JFN:   So far we have discussed the impact of low interest rates on various markets.  What does a very prolonged period of exceedingly low – essentially zero – interest rates mean for capitalism itself?

SCDJ:  Could this prolonged zero interest rate environment represent the beginning of the end of capitalism?  That is a huge call to make.  But in the whole era of market-based capitalism, we have never seen interest rates and the rewards for the providers of finance this low.  In capitalism, investors are expected to be compensated for the risks taken, particularly with debt investments.  With no yields there is no compensation for the risks being taken.  So, how should we interpret a developed world where there is no yield?  Is this essentially global socialism?  If investors aren’t rewarded for investing, why invest?  More directly, if an investor invests without any potential return why are investors putting capital at risk?  Will banks be forced to lend for some greater purpose even though they make no money for doing so?  Isn’t that sort of the definition of socialism?  In socialism, economic activity occurs, just because the government wants certain activities done.  Even if the activities don’t produce a positive financial return there may be some social benefit for doing it.  Perhaps that is where the developed world finds itself.  Perhaps the more compelling question is what do capitalist countries do to move back away from socialism towards capitalism?  Do you have a view on what central banks can do to precipitate that directional shift?

JFN:   Now you are asking the questions!  And I am well aware of the dangers of a trans-Atlantic discussion of whether socialism is desirable, or even what it is – this is one field where we really are two nations, two continents even, divided by a common language.  But whether it is socialism or not, I do think central banks may end up more closely aligned to finance ministries – their independence is anyway somewhat imaginary, and will increasingly be eroded as they are asked to operate quasi-fiscal policies as part of the authorities’ overall attempts to manage the increasingly difficult task of steering a national economy in a globalised financial world.

SCDJ:  But if that happens, and central banks become more politically motivated, what happens to capital markets?

JFN:   Markets will operate very differently, because as you have observed the main market incentive for asset owners to provide finance and take risk (i.e. the return element) is either absent or heavily reduced.  In such a world, if there is no market reason to lend, then society will almost certainly provide legislative reasons.  These can be either “use it or lose it” type rules (i.e. heavy taxation of un-invested cash), or compulsion rules – legislation forcing pension funds to invest in state debt, infrastructure bonds and so on.  We may decry this as financial oppression, but to a certain extent banks, insurance companies and pension funds are already subject to regulatory requirements that force them to make investment decisions on grounds other than risk and return.

SCDJ:  But would asset owners not simply flee to another country, or take physical cash and hold it outside of the banking system?

JFN:   I’m not sure that serious asset owners have the option of physical cash, though the traditional safe haven assets like gold (which is nobody’s liability) might come more into vogue for those seeking to escape the state’s tentacles.  But more generally, capitalism’s response to financial repression would naturally be for capital flight from over-regulated markets to freer jurisdictions.  This will give a further boost to companies domiciled in less regulated jurisdictions, as people strive to get their money away from confiscatory regimes.   Of course the official response to capital flight is capital controls; and you will have observed that the IMF has recently changed its views on capital controls (or “capital flow management techniques” as they delicately refer to them) to allow that “in certain circumstances” they have their place.  And while I don’t think the IMF was consciously preparing for a world of financial repression and state direction of assets, it will certainly help those governments that want to dictate more closely what their citizens do with their money.

SCDJ:  Does that mean tax regimes become more similar around the world, or more different?

JFN:   Ultimately, I think states face a shrinking tax base and are losing the ability to tax.   Property, being immovable, remains taxable, and economic activity can be taxed via sales taxes or turnover taxes like VAT.  But in a global and largely service-driven world, states will I think find it ever more difficult to attach their tax demands to financial flows or assets.  This could bring into even sharper relief the distinction between where companies do their business and where they have their legal domicile.  The current disputes over taxation of global corporations is merely a foretaste of battles to come; indeed, as a radical thought, why does a company need to be domiciled anywhere at all?  Could it not be domiciled in a non-state (e.g. Antarctica), or on a ship on the high seas, or even on the Moon?  Granted, a domicile in a particular nation-state does provide a certain rule of law, but that will have to be balanced by the costs of being domiciled in that particular location – we can see this playing out in the US right now.

SCDJ:  Well, we started by considering the end of positive interest rates, we moved to the possible demise of free capital markets, and you now appear to envisage the end of the financing basis for whole states.  Surely that is not going to happen?

JFN:  No, I don’t think so, or at any rate not in our lifetime!  But we will see an increase in the divide between the rich global elite (individuals and companies) and the rest of us.  As the saying has it, the rich live in another world – and increasingly, they will for taxation purposes as well.