The End Of The 4-Decade-Old Cycle Of Declining Interest Rates Ushers In An Era Of Harder Times

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by: Zoltan Ban
Summary

A four-decade super-cycle of declining interest rates has come to an end. The global debt/GDP has doubled since then, raising questions of continued sustainability.

One of two possible outcomes involves a start of a long period of debt deleveraging, which would involve immediate pain.

The second and perhaps more likely outcome may involve the beginning of a period of massive government deficit spending which will temporarily fill in the gap, leading to postponed pain.

With the global economic recovery in its ninth year, and countless expressed worries about the viability of the recovery proven wrong along the way, this economic cycle is increasingly starting to get the feel of being invincible. Sure, we have been experiencing a bit of a stock market volatility in the past few days, but I think most people assume that it is not the beginning of anything that should worry us. We just got a significant tax cut, which should provide stimulus to the economy. Companies are supposed to start investing at least a part of their windfall into the real economy. Consumers are supposed to provide the fuel that will spur investment, as they too will spend their tax cut windfall. Of course, it is entirely possible that consumers will see the extra income as a much-welcomed chance to stem the continued growth in consumer debt servicing costs.

Source: Federal Reserve Bank of St. Louis

While interest rates have been on a downtrend, as we can see consumer debt-servicing costs stopped declining a few years ago, and are now once more on an upswing. It is important to note that these rising servicing costs did not come about due to rising interests, because interest rates have only started rising recently. In fact, many people have been slashing their interest rate burden during this period by refinancing at lower rates. Despite that, we are close to reaching interest cost levels as a percentage of disposable income to levels we were at on the cusp of the great financial crisis.

The tax cuts that the average middle-class home will experience will range between $500 and $2,000/year, which might just be enough to cover the continued increase in debt servicing costs that we are experiencing.

Source: NPR

We should keep in mind that we seem to now be on the verge of a very long-term reversal in interest rate trends, which might on balance lead to consumers having to give most of what they are getting in tax cuts on higher interest payments in the years ahead.

Source: Federal Reserve Bank of St. Louis

As we can see, the consumer, as well as governments, business, and any other borrowing entity we can think of have been benefiting from a trend of declining interest rates that kept providing relief on a more or less a constant basis since the early 1980s. All indications are that the trend has ended, and at the very least, interest rates will not decline any longer. I cannot stress enough the fact that at this point, we don't even need to see an increase in interest rates, because global debt keeps expanding at such a high rate that the interest rate burden, whether expressed as a percentage of GDP, revenues, income or any other measure of available funds will increase from now on, even in the absence of increased interest rates. The growing debt-servicing burden is being driven almost exclusively by the growth in the size of the debt itself.

Source: Business Insider

As we can see the debt pile as a percentage of GDP keeps growing, and so will interest payments, even if there were to be no increase at all in interest rates. The only thing that kept interest costs manageable in the past four decades or so was the constant trend of declining interest rates.

Looking at the global debt/GDP chart, as well as the US 10-year bond yield chart, there seems to be a clear correlation between the decline in interest rates and the beginning of the increase in debt/GDP, which more or less doubled from about 120% to about 240% between 1980 and the present. My guess is that the lower interest rates facilitated this increase, without which interest costs would have also doubled as a percentage of global GDP, which would have been unsustainable. I do believe that without this increase in debt, the global economy would have seen much slower economic growth during the past four decades. The obvious question then has to be, what will happen to the global economy in the absence of such continued interest rate relief, given that we most likely hit the bottom in interest rates in the past few years, with very few opportunities left to refinance debt as the current low rates? Are we entering a period of declining global debt/GDP, in other words, debt deleveraging? If so, how will that affect economic growth? And if global economic growth will slow further, what will that mean in terms of our ability to continue servicing our debts?

What is awaiting us going forward is the classic vicious cycle scenario that tends to occur when a period of debt deleveraging is upon us. The four-decade-old interest rate decline cycle can no longer provide debt servicing costs relief, because we basically reached the bottom of the cycle. At best, we can still hope that interest rates will not rise. But as long as the debt/GDP accumulation cycle continues, there is a very real danger of interest costs as a percentage of our collective financial resources seeing a similarly rising trend, which is likely to lead to one of two outcomes.

The more immediately dangerous outcome would be an end to the decades-old trend of increasing debt as a percentage of global GDP. The outcome of such an event would most likely be similar to what we saw in Greece after the global financial crisis, where an effort to stem the continued growth of its debt bubble led to years of economic contraction, which in turn made it harder to stem the continued rise in its debt/GDP at government level. We should keep in mind that Greece benefited from massive perpetual bailouts throughout it all, while the world is simply too big to bail out, aside from central bank action of course. But even the ability of central banks to coordinate and do something in case that this hypothetical situation comes to pass is put into question. Interest rates have been kept low throughout the past decade or so, leaving little room for stimulus.

Bond buying programs may work, but it is questionable for how long. Money printing always leads to asset price bubbles. Arguably, we are seeing that in the stock markets among some of the most prominent examples of that. For instance, the S&P P/E ratio is currently just under 25, while historically it tends to be around 15. An excess of liquidity may eventually run out of such assets to inflate, and some more dangerous asset inflation trends may arise, such as commodity price inflation for instance, which could potentially lead to overall inflation in the economy, giving rise to the threat of self-sustaining inflation at higher rates than desired. That in turn may force central banks to reverse course and tighten liquidity.

In effect, we can view the doubling of global debt/GDP since 1980 as a bubble, which was sustained for four decades by a steady trend of lower and lower interest rates. With the declining interest rate trend which sustained it up until now at end, there may be nothing else much that could continue to sustain it, giving rise to the prospect of it bursting. It would be the first truly global debt bubble crisis, and I am not sure how painful it will be, nor can I imagine what if anything could potentially pull us out of such a crisis. The 2008 crisis for instance saw a combination of massive government debt spending, interest rates dropping, and China engaging in a massive stimulus program all coming together to eventually restart the engines of growth. I don't believe we will have any of that going into the next global downturn.

The second potential outcome of this situation we are in is a continuation of the bubble, which may still have some resources going into it to keep it in its current inflated form. Interest rate relief is no longer available, but governments around the world could still engage in increased deficit spending. The CBO projects that this is exactly what the US government is set to do for the next decade.

Source: CBO

We should keep in mind that the effects of the latest tax cut are not incorporated in this forecast. Latest spending bills also suggest there will be added deficit spending going forward. Most projections suggest that there will be a significant increase in deficits due to the tax cuts, which would come on top of what already seems to be a dangerous debt trajectory. We also have an assumption of no recession between now and 2027, which is also rather optimistic, in my view, although it could potentially happen. If other major governments around the world will follow suit and engage in elevated deficit spending as the US is seemingly set to do, it is entirely possible that the global debt bubble could be maintained, at least for as long as major governments around the world will be able to continue financing their deficits.

While this scenario would help keep things going for many more years, perhaps even more than a decade, it goes without saying that it will come at a steep price, given that it would involve further debt accumulation. Most major economies in the world are already on a debt-accumulation path, which comes on top of already high levels of debt.

Data source: Trading economics

If this trend of debt accumulation as a percentage of GDP will accelerate, it goes without saying that it will not take long for many countries to experience a sovereign debt crisis.

While there is absolutely no way of telling whether the end of the declining interest rate super-cycle, which helped stimulate the global economy for the past four decades, will have imminent negative consequences, or whether certain policies may help kick the can down the road, the undeniable fact is that the cycle did end. With this, one thing that we can be sure of is that regardless whether economic hardship is imminent or whether we will be able to postpone the pain, with the end of this cycle, we are most likely looking at a very different economy from now on. We may already be living through it; it is just that the effects are not yet being felt.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.