Central banks still facing pressure from trade shocks: Economist
Bloomberg Businessweek -- It’s hard to wrap your head around just how low U.S. interest and bond yields are—still are—a decade after the Great Recession ended. Year after year, prognosticators said that rates were bound to go back up soon: Just be ready. That exercise has proved to be like waiting for Godot.
In 2018, Jamie Dimon, chief executive officer of JPMorgan Chase & Co., put Americans on alert to the likelihood of higher interest rates. He said the global benchmark for longer-term rates, the yield on a 10-year Treasury bond, could go above 5 per cent. Right now it’s just a hair above 2 per cent. Thirty-year mortgage rates are a fraction of long-run averages, and companies too are paying very little to borrow. All that cheap money has been helping the economy along. On the other side of the ledger, bank depositors are getting paid only a fraction of 1 per cent on their savings.
The longevity of low rates has upended long-standing assumptions about money and reshaped a generation of investors, traders, savers, and policymakers. The Federal Reserve has tried to push the U.S. into a higher-rate regime, raising rates nine times since 2015, when the key short-term rate was near zero. But now the central bank appears ready to reverse course and start cutting again when it meets at the end of July. “This is the new abnormal,” says David Kelly, chief global strategist at JPMorgan Asset Management, which oversees US$1.8 trillion. “Normally when you are in this phase of an expansion, you have a rising inflation problem, a Federal Reserve overtightening to slow the economy, and businesses that can’t afford to borrow. None of that is true right now.”
Investors are betting that a quarter-percentage-point rate cut is all but certain, according to prices in the futures market. Fed Chair Jerome Powell reinforced those views with remarks to Congress on July 10 and 11. He cited rising global risks, low inflation, and weakening business investment and manufacturing. Depressed U.S. rates come as other central banks, including the European Central Bank, have turned more dovish—even with their rates already set below zero.
Anne Walsh, chief investment officer of fixed income at Guggenheim Partners, says there’s been “a paradigm shift of epic proportion for investors.” Not only are short-term rates low, but long-dated bond rates are minuscule, too, suggesting that investors see little likelihood of rates—and the economic conditions they reflect—changing anytime soon. (Bonds’ yields fall as their prices rise.)
Borrowers of all kinds have been clear benefactors of this sea change, with many nations and companies locking in low rates for as long as a century. Belgium and Ireland have sold 100-year bonds, as did Austria this year at a yield of 1.171 per cent. In 2015, Microsoft Corp. sold 40-year bonds and the University of California issued 100-year debt. Subdued rates have also buffered the U.S. Treasury from rising interest costs on the federal debt.
For banks, the squeeze in long-term rates isn’t ideal. That’s because they tend to fund long-term investments with short-term debt, so they prosper when long-run rates are significantly higher than short ones. In the U.S., banks have still been able to profit, with the top five firms cracking US$30 billion in quarterly earnings for the first time. But some big commercial banks have warned that lower interest rates are weighing on their outlooks for revenues from lending.
Individuals have had to get used to earning paltry rates. The national average rate on savings accounts is 0.10 per cent, little changed from four years ago and down from 0.30 per cent in 2009, according to data from Bankrate.com. In 2000, well before the financial crisis, the rate was 1.73 per cent. “We never got to the would-be promised land with respect to higher rates,” says Mark Hamrick, senior economic analyst at Bankrate.com. “This has been the difference for savers between having more money and not.”
The problem is the same for institutions that manage savings on behalf of others. Pension funds, overseeing trillions in retirees’ future cash, have been ratcheting down return expectations. The 30-year Treasury bond, a favored debt security, yields about 2.5 per cent—compared with an average 6.5 per cent since the 1970s. Even a record rise in stock prices hasn’t solved the low-return problem for pension funds, because many of them cut their allocations to equities after the financial crisis. Ben Meng, chief investment officer of the California Public Employees’ Retirement System, said in June that the expected return for his pension portfolio over the next 10 years would be 6.1 per cent, down from a previous target of 7 per cent.
Where low rates really bite isn’t in current returns but in the future gains investors can reasonably expect. Interest rates set a kind of baseline for the return on all assets. As they fall, bond values rise and stocks often do, too. But once rates have settled at or near rock bottom, there’s less room for that kind of price appreciation.
All this has sent investors looking under every available rock for more return—even if it means taking more risk. The fear is this could lead to the formation of bubbles and eventually destabilize the financial system. “Institutional investors are out there in the great truffle hunt for yield,” says Walsh, at Guggenheim. “This is particularly true of large institutions, like banks and insurance companies and pension funds. These firms are searching for yield and potentially taking on unintended risk because that is what they need to do.”
It’s a global phenomenon. Japan Post Bank Co., the banking unit of Japan Post Holdings Co., a publicly traded company that’s majority-owned by the government, held US$577 billion in bonds outside its low-yielding home market in March. Norinchukin Bank, a cooperative that invests the deposits of millions of Japanese farmers and fishermen, has US$69 billion in collateralized loan obligations—essentially, loans to companies with less-than-stellar credit—in the U.S. and Europe.
While some Fed officials wish they could get back to more-normal rates, so they have more room to ease again in the future if they need to fight a downturn or fresh financial crisis, they seem to have their hands tied. For all the problems low rates may cause, policymakers see them as a stimulant to growth. Although unemployment rates are very low, the economy took an agonizingly long time to recover from the financial crisis. And now a slowdown in global growth and headwinds from Trump’s trade war have made risks to U.S. output too strong to ignore.
This has some wondering if we’ve been thinking about the economy all wrong. “The traditionalist views on monetary policy and monetarism are really being questioned,” says Mark Haefele, chief investment officer at UBS Global Wealth Management, referring to to the notion that central banks always have the ability to juice the economy—or put the brakes on it—when needed. “That has led to a wide range of alternative theories including Modern Monetary Theory, and just how to re-stimulate growth.” According to MMT, for example, government policymakers should be willing to run bigger deficits, at least until a boom in demand causes inflation to kick in.
The surprising persistence of low rates has even quietly reordered the hierarchy on Wall Street. Hedge fund managers may still be glamorous on shows like Billions, but in real life they’ve had to fight to retain clients. Partly that’s because many hedge fund managers thrive on volatility, and in a world where the dreaded spike in interest rates has never arrived, there’s been too little of that for them. The long fall in rates has made it easier so far to earn money with simple investments such as stock and bond index funds. Meanwhile, cheap financing costs and rising asset values have been a boon for private equity firms. Investors have committed about US$4 trillion to them in the last decade, according to data from research firm Preqin Ltd.
In 2009, bond powerhouse Pacific Investment Management Co. saw all this coming, when they dubbed their multiyear investment outlook “the new normal” and predicted lower long-term yields. They saw the same issues the Fed and central bankers around the world are grappling with now: slow growth, a combination of technological innovation and low-cost global labor that eases inflationary pressure, and a glut of savings as the populations of rich countries age. Looking ahead, with many of those 2009 factors remaining, “the new wrinkle is concern around global trade and countries looking more inward,” Pimco Group Chief Investment Officer Dan Ivascyn says. “Yields can absolutely go a lot lower.”
—With John Gittelsohn, Christopher Anstey, Ben Holland, and Michelle F. Davis