Making sense of Zero interest rates
What we need to know about the fall in interest rates.
The recent developments in global interest rates followed by the market's reaction to these developments fail to be anything less than dramatic. The question of a zero or negative interest rate environment has been going on for decades, a subject of political and economic controversies, and we've experienced this on multiple stints post the GFC in 2008.
In a scenario where rates are too high, economic activity is low, conversely, where interest rates are too low, economic activity is high as a result of high asset prices or inflation. Technology and globalization have brought us to a place where interest rate hikes no longer make sense.
Economists agree that the principal goal of policy at zero rates is to increase aggregate demand (consumer spending), not aggregate supply (production). However, aggregate supply is an underlying factor to determine future inflation.
While in 2019 the global debt underwriting hit record levels, interest rates in current markets have seen the most unprecedented lows — for the amount of debt that is out there. Calculations in the trillions are prevalent, but this may be about to change, with global debt having crossed US$253 Trillion by Q3 2019, a now rare term "quadrillion" is on the horizon. At the beginning of this year, over $10 trillion of global debt traded at negative yields. It is no surprise that the framework and the effects thereof by application of monetary policy have become so complicated especially in Europe and Japan where negative interest rates were imposed — this has made the stimulus more difficult. I am not clear about how deep an impact we can have given the current market scenario, however, we know that it would take a protracted amount of time to have this come back to the levels we saw at the dawn of the 20th century.
When Ryan Gosling walked into that room pitching the credit default swap, we learned that the foundation of the mortgage crisis, which was based on the purchase of derivates against mortgages to inadequately qualified buyers. Governments and central banks around the world managed the crisis by handing down extensive stimulus packages. Amidst a global debt scenario at such unprecedented levels together with the yield curve undergoing two inversions at the end of last year, we had a second chance, but COVID.
We are now at the point when the world will be punished for 35 years of excesses which is the culmination of the 100-year experiment of fiat money started by the Fed in 1913 — James L. Ausman
From a personal standpoint, we can expect:
- Credit cardholders to see a reduction in their annual percentage yields in a couple of billing cycles. While this may not necessarily save lives, it is wise to start a debt snowball — read more about the snowball and avalanche methods here.
- With interest fallen, loan refinancing could save hundreds of dollars in interest charges.
- With the interest rates essentially zero bound, expect zero bound savings gains. This, however, could be an opportunity to lock in higher fixed deposit rates.
- Forget about any gains with auto loans, save the cash and the trouble.
A zero interest rate environment, though lagged can have the following macroeconomic impact:
- Inflated Asset Prices
- Labor Contraction
- Capital Tax cuts
- Increased Government Spending
Governments around the world are striving to stimulate growth and boost demand but at the cost of high debt to GDP ratios. The global average debt to GDP ratio stood beyond 320%, which was significantly greater than the 226% in 2018 which was only about 1.5% points above the previous year. Many emerging market economies were ill-prepared for this and in short, could not have come at a worse time where US$72Tn represented sovereign borrowers and US$ 69Tn represented by non-financial corporate borrowers — as reported by the Institute of International Finance. Don't get me wrong, I don't believe that this is the time to fret about the potential issues associated with government debt, I believe that they are all doing the right thing. While public health is of utmost importance, it is important to be advised that this crisis will push governments to unchartered territory.
When the Nazi government in 1933 declared a unilateral default on all its sovereign debts, a significant portion of its debt was written off by the US and the UK. History and evidence suggest that this type of forward-thinking and resolution oriented approach is necessary to combat existential threats of the pandemic.
At the end of every seven years you must cancel debts. This is the manner of remission: Every creditor shall cancel what he has loaned his neighbor. — Deuteronomy 15:1–2
I share the view that Reinhard and Trebesch conclude in their paper "Sovereign Debt Relief and its Aftermath" that crises exits came after deep discounts in the face value of debt and that softer forms of crisis resolution such as rescheduling of debt, moratoriums and other similar forms of debt reliefs add very little weightage in solving the debt crisis. Many such reliefs have been dragging on for several years. This theory supports the book of Deuteronomy from the Bible estimated to be written between 7th and 5th century BC, where people were instructed to write off debts every seven years, which makes me wonder if our global debt burden would still exist.
