Tuesday, February 2, 2016

Ultra Low Rates For Years?

David Brown wrote an excellent comment for the South China Morning Post, Major economies will be saddled with ultra low rates for years:
Global markets are digging themselves into a deep hole. Sheer panic seems to be setting in over the spectre of world economic slowdown, chronic deflation worries and financial markets caught in a tail-spin. 2016 is shaping up as another painful phase of the seven-year-old global financial crisis.

The trouble is that global policymakers seem to be running out of fresh ideas to deal with this new leg of contagion. The major central banks have already deployed most of their monetary armoury in dealing with successive waves of the crisis since 2008.

Global central banks are close to running on empty. Interest rates have been slashed to rock bottom levels and a tonne of quantitative easing has already been thrown into the monetary reflation pile.

There is one very obvious clue to what happens next. Interest rates either need to go a lot lower or else the QE generators need to get cranked up again. The implication for markets is that the major economies will be saddled with ultra low rates for years.

It is causing mayhem for monetary policymaking and forcing rushed decisions. The European Central Bank is already setting the stage for another likely deposit rate cut in March, which will push euro zone rates even deeper into negative territory. [The interest rates of G7 nations are converging towards the Japan model, which have been hovering near zero for 20 years.] The interest rates of G7 nations are converging towards the Japan model, which have been hovering near zero for 20 years.

The Bank of England is also having second thoughts about monetary policy tightening and looks set to postpone a well-flagged plan to hike UK interest rates until at least 2017. The central bank believes the UK economic outlook is too fragile to sustain higher rates at this stage.

Deepening financial market turmoil will also stop the US Federal Reserve dead in its tracks on rate tightening. Despite the strength of the domestic economy and extremely positive employment trends in recent years, the US central bank is fretting again about the weakness of the global economy.

Worries about China and the fragility of emerging economies, especially Brazil and Russia, could put future US rate hikes on ice for a long while. And if conditions start to deteriorate much further, threatening to derail growth altogether, the Fed could be pushed into a dramatic policy U-turn. Last December’s rate rise would need to be reversed and the Fed might even need to consider kick-starting QE again to extend its bond-buying programme.

If the global slowdown starts to get out of hand and deeper deflation persists then interest rates around the world will continue to converge towards zero and remain that way for a long while. The Fed slashed rates near to zero at the end of 2008 and held them there for seven years. The same fate could befall other economies over coming years.

The experience of Japan in the last three decades is bound to resonate. From the mid-1990s onwards, Japan has struggled with episodes of recession, weak recovery and chronic deflation. Even after repeated rounds of government and Bank of Japan policy interventions the economy is still struggling. The legacy has been interest rates stuck at ultra-low levels for 20 years.

A global crash is not inevitable. Markets seem to be turning a drama into a crisis, but it is no hard landing yet. Growth in China may be at its weakest for 25 years, but it is still robust at 6.9 per cent. Underlying economic growth running around 2 per cent in the US and UK looks reasonable too. Even the euro zone’s underlying 1.5 per cent growth rate is far from being a disaster. Growth simply needs to be re-energised.

Global policymakers can call a halt to the slide, but they need to make a united stand, to think and act together. The ECB’s hint last week that it might add more monetary stimulus in March is a positive step, but more needs to be done by other central banks too.

The leading nations need a much more coherent and co-ordinated strategy to deal with damaging global headwinds. By working together through supranational bodies like the Group of Seven, G20 and International Monetary Fund, the leading nations can make a difference.

Better co-ordination of monetary and fiscal reflation on a broad front could turn the tide. And the major nations should avoid competitive currency devaluations which are little more than short term beggar-thy-neighbour palliatives.

The world economy can avoid becoming a victim again. Global policymakers simply need to pull together and promote the right remedies to beat the blues. Urgency is the watchword now.
On Friday, I wrote a comment on the new negative normal which I subsequently edited over the weekend to include comments from former chairman Ben Bernanke who said the Federal Reserve should consider using negative rates to counter the next serious downturn:
“I think negative rates are something the Fed will and probably should consider if the situation arises,” Bernanke said in the interview last month.

Read full interview: Bernanke: I never expected 0% rates to last so long

Former Fed Vice Chairman Alan Blinder urged the Fed during the financial crisis to set negative interest rates for overnight deposits — essentially charging banks a fee to park funds at the central bank.

Blinder argued this would force banks to find more productive uses for the money.

Bernanke and his colleagues opted not to push interest rates below zero, worried that the costs outweighed the benefits. In particular, there was a concern that money-market funds wouldn’t be able to recover management fees.

But experience in Europe has shown this fear was unfounded.

In the region, the European Central Bank, the Swiss National Bank and the central banks of Denmark and Sweden have deployed negative rates to some degree.

For instance, earlier in December, the ECB cut its deposit rate to negative 0.3% from negative 0.2%.

Bernanke said he was surprised by how negative rates have been able to fall in Europe.

Bernanke suggested negative rates can’t be the Fed’s primary tool to combat a recession.

“The scope for negative nominal rates is fairly limited,” he said.

At some point, people begin to hoard cash, which has a zero interest rate, he noted. And quirks in the U.S. financial system also limit the utility of negative rates, he said.

Bernanke said he hadn’t heard anecdotes of ordinary people being affected in Europe, as personal checking accounts are not paying negative rates.
We can argue about the scope of negative nominal interest rates and quantitative easing, but there's no denying that central banks are the only game in town and there's a deflation tsunami coming our way which means ultra low rates or negative rates are here to stay.

Bloomberg reports that factories in the euro area slashed prices of goods by the most in a year in January, highlighting the deflationary risks that’s keeping alarm bells ringing at the European Central Bank. And the Korea Times reports that consumer price growth fell to below 1 percent in January, stoking worries of deflationary risks.

I know of a few large public pension funds in Canada, like the Caisse, that have systematically got it wrong on the direction of interest rates and they're not the only ones buying Wall Street's garbage on the "busting of the bond bubble."

Bursting of the bond bubble? Tell that to all those JGB bears who got their heads handed to them over the last 20 years betting against Japanese bonds. And now that the Bank of Japan has joined the "negative rate club," these JGB bears are getting massacred.

I've long argued that when it comes to asset allocation, you need to keep in mind six major structural issues:
  • The global jobs crisis
  • Aging demographics
  • The global pension crisis
  • Rising inequality
  • High and unsustainable debt all over the world
  • Technological advances 
Now, we can argue about how much each of these structural factors contribute to global deflation, but there's no doubt that they exacerbate deflationary headwinds all over the world and that's why rates will remain ultra low for years to come.

What are the implications of deflation and ultra low or negative rates that could last decades? Well, for one thing, it means we should expect much lower returns ahead and a lot more volatility in financial markets as risk premiums get crushed across the board.

This is just common sense. The yield on the 10-year U.S. Treasury bond currently stands at 1.86% and it's dropping fast along with oil prices. This means institutions looking to make an annualized target rate-of return of 7% nominal or more over the next decade need to take a lot more risk to achieve that return.

Where are they taking that risk? In stocks, corporate bonds but increasingly in illiquid private equity, real estate and infrastructure and also in hedge funds that promise absolute returns even though they're incapable of escaping the market carnage.

But if rates remain ultra low, won't that be good for residential and commercial real estate? Not necessarily. If deflation becomes entrenched, low rates will exacerbate debt and increase unemployment at the worst possible time. It can easily spiral into a debt deflation crisis and you'll see rising vacancy rates and/ or declining rental rates.

In this environment, real estate is the asset class that makes me most nervous. This is especially true in prime markets like New York and London which rely on vibrant financial markets. They're going to suffer the most because they rose the most since 2009.

But it's not just real estate that will suffer if deflation becomes more entrenched. All asset classes will exhibit a prolonged period of low or negative returns except for...good old nominal bonds!

Still, there is a titanic battle over deflation going on and central banks aren't going down without a fight. This means there will be plenty of opportunities to capitalize on short-term swings in these markets but individuals and institutions will need to get more accustomed to volatility and playing a game which isn't exactly easy to play even for the most experienced traders.

I know, I trade these markets, I'm on these markets and see firsthand how tough they are to trade. I don't care who you are, it's a brutal environment out there. Period.

Below, Russell Rhoads, education director at the Chicago Board Options Exchange’s Options Institute, explains the change in the volatility regime.“We actually appear to be coming out of a low-volatility regime and going into a high-volatility regime, which is normally characterized by VIX "spending more time in the 20s,”  he says.

But he also adds: “The VIX was elevated going into 2016 and has stayed up in the 20s without the same sort of follow-through to the upside that we saw in August because there's been a lack of surprise, for lack of a better term.”

What this means is that while the market is extremely edgy, there's a lack of complacency, and there's room for an upside surprise in the near term. I stick by my comments on why the bloodbath in stocks is over and why oil's nightmare dominated Davos.

I'm still waiting for high beta stocks, especially high beta biotech stocks, to decouple from oil but that's proving to be very difficult in an uncertain environment where deflation fears reign. Still, stay tuned, when rates are ultra low for years, you just never know where the next bubble is brewing!!

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