Almost one third of government debt in developed markets already yields less than 0%.
Inflation and economic growth remain persistently low, 10 years removed from the Great Recession.
Chairman Powell may have to entertain unconventional policy measures in the advent of an actual recession.
Low or negative interest rates may be the only thing that keeps western economies solvent.
Central bankers convened in Wyoming last week for their annual meeting. Interest rates are collapsing everywhere. In the last six months, a third of them have executed explicitly accommodative policies. Federal Reserve chairman Powell stated that there were "no recent precedents to guide any policy response to the current situation.” It's my view that he will have to force short-term rates below zero if and when the US economy falls into recession.
We are now more than 10 years removed from the Great Recession and it appears that the world is lapsing back into another round of interest rate repression. There are strong political and economic incentives for rates to fall below zero here in the US.
There is some objective rationale for a coordinated easing of interest rates. Independent forecasts of global economic growth are mediocre and have deteriorated a bit recently. The IMF recently reduced its forecast for 2019 global growth to 3.2%. Advanced economies are expected to do worse.
The world's premier economic powers, the USA and China, are facing off in a disruptive trade war. Federal Reserve minutes released this week reflect a view among the central bankers that the current conflict will be a persistent headwind to economic growth. Some estimate that US GDP will lose 0.3% each year the trade war continues. Many large European economies have stalled and Britain's exit from the EU will almost certainly reduce trade flows.
The USA is not in a recession now but more and more economists are forecasting one. Nearly 3 out of 4 economists surveyed by the National Association for Business Economics expect a recession by 2021, according to poll results released this month. Even if this survey is alarmist, it's reasonable to consider precedent in order to gauge a Fed policy response. At the onset of the last nine recessions dating back to 1957, the Fed Funds rate was significantly higher than the 2.25% currently targeted. In every case, it was reduced by more than 2.25% before the economy recovered. Usually, the rate cuts were far higher.
We should also consider the context of any Fed action in the near future. Over $16 trillion in bonds are now yielding negative returns - an unthinkable scenario ten years ago. That's about 30% of all the government debt outstanding in the developed world! Oddly, this massive infusion of liquidity into the monetary system has spurred neither rapid economic growth nor inflation.
There are plenty of holders of this negative yielding debt - so far with little to complain about. The iShares International Treasury Bond ETF (Ticker IGOV), heavily weighted toward European government debt, has returned 5% so far this year.
Accommodative monetary policy is nothing new. Very low rates were employed during the Great Depression. In fact, treasury bill rates were at or near 0 during much the 1930s while commercial paper yielded less than 1%. But we ain't in a Great Depression now. The world economy has grown continuously since 2009.
The new wrinkle in the system is the growing role that debt plays in the world economy. The IMF has aggregated debt claims worldwide since 1950. The chart below reveals that debt has grown much faster than the world economy over the past 70 years. This is especially troubling in the developed world, with an aging population more inclined to collect pensions than repay loans.
The nominal dollar amount of debt has swelled to nearly $250 trillion. Those loans need to be serviced at prevailing interest rates. The Great Recession of 2008-09 necessitated very loose monetary policy. Nothing new here. The severity of the recent slump spurred central banks around the world to purchase a massive amount of financial assets to depress interest rates. The balance sheets of the world's four major central banks swelled from about $5 trillion in 2007 to $19.4 trillion today.
Source: Yardeni Research
This time around, though, the response of the real economy was tepid. World GDP growth rates remained at or below 3.0%, Prior recoveries typically demonstrated higher growth from far shallower troughs in economic output.
Despite the massive amounts of liquidity injected into the banking system, inflation has remained stubbornly quiescent. Our own Federal Reserve Bank has struggled to maintain its target rate of 2.0% inflation even as unemployment rates have fallen to near historical lows. Inflation rates in Japan and the eurozone are even lower.
Many economists have speculated about the causes of low inflation. Aging populations, technology, automation, and globalization have all been postulated. Maybe people's own expectations about interest rates have been reframed. There is no clear answer.
Political leaders in the West are beset with their own problems. public and private debt is growing faster than their economies. Aging populations will make servicing this debt more difficult going forward. They are demanding health care and pensions, not higher taxes. The fall in interest rates has been tacitly accepted by the political class (Donald Trump is not so tacit). Indeed, Western economies are receiving a windfall from these low interest rates.
Advanced economies will spend just 1.77% of their combined GDP on debt interest this year, according to the OECD - the lowest since 1975 and down from a peak of 3.9% in the mid 1990s.
Despite massive deficit spending in the west, the price tag of debt has fallen. Cheap money has had a major impact on the world capitals. Policymakers in Washington recently agreed to a budget deal that adds $320 billion to existing spending caps and balloons deficits into the foreseeable future. There is no longer even a pretext of fiscal probity in either political party.
“It’s pretty clear that both houses of Congress and both parties have become big spenders, and Congress is no longer concerned about the extent of the budget deficits or the debt they add,” said David McIntosh, the president of the Club for Growth, a conservative group that advocates free enterprise.
What of this new world of negative interest rates? They now prevail in nations that, at worst, have sluggish economies. It's been ten years since the last recession. What are bankers to do in the event of an eventual downturn. Policy options are limited.
The short rate in the US is about 2%. There is a little room to cut, but frankly, the banking system already has over $2 trillion in excess reserves on deposit at the Fed. Years of easy money have inured lenders to the boundless liquidity available to them. While small interest rates cuts may help at the margin, it's fair to say that the US Federal Reserve and other central banks will have to get pretty novel in the event of an actual recession.
Chairman Powell may have to accommodate the tide of rising liquidity around the world by reducing rates below zero. His political brethren in Washington will hardly object. They have social programs to fund and taxes to cut. There is no appetite for sacrifice. Even business people are calling for longer dated bond issues to lock in these lower rates and pay for infrastructure.
Think of low interest rates as a party fueled by the financial equivalent of methamphetamine. Like the addict, the economy requires more and more stimulus to run in place. It's a worrisome state of affairs. However, it's a drug that has yet to reveal adverse symptoms. The party will go on because the party must go on.
Disclosure: I am/we are long IGOV, AGG. 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.
Additional disclosure: Here is my revision pursuant to your feedback on Sunday, 08-25-19