US interest rates are headed back to 0
By Siddhartha Jha on The Capital
One of the greatest attributes of markets is that they are highly efficient processors of information. They are not always right but they are the best option we have to quantify large social systems such as our economies. Among the plethora of markets, interest rates are one of the largest and most important signals of where the economy is headed. In this article, the main interest rate we will be concerned with is that of US Government debt (aka Treasuries) as they form the bedrock of other interest rates and other markets. Interest rates determine the cost of capital and risk aversion, thus fueling buying or selling in other, riskier assets. In simplistic terms, your appetite for investing in stocks, commodities, cryptos, or the latest idiotic money losing startup from Silicon Valley would be very different if your bank account paid you 5% interest versus 0%. The question of where markets such as stocks, commodities, or foreign exchange are headed often is best answered by first thinking about where interest rates are headed.
Before we get into where interest rates may be headed, it is important to understand what drives them. Though there are many complex drivers, the key variables are growth and inflation. Inflation refers to increases or decreases in prices. When inflation is high and prices are rising, the same dollar today buys fewer goods and services a year from now, which makes loans or savings accounts with fixed interest rates less attractive. Interest rates have to rise to keep up with the declining purchasing power. In conjunction, strong economic growth makes assets such as stocks are more attractive and interest rates have to rise to compete. Strong economic growth can itself lead to future inflation as demand for goods and services may rise faster than supply, which further fuels higher interest rates. The opposite effects play out with lower economic growth or lower inflation. To simplify, lower interest rates are a position for weaker economic growth and declining inflation and vice versa for higher interest rates. As with all markets, interest rates move on future expectations of its driving variables instead of their current state meaning expected growth and inflation (See Interest Rate Markets by Siddhartha Jha).
To answer the question that started this article, yes, many signs are building up that US interest rates are headed to 0. By “US interest rates,” I mean the 0–2Y rates at the front end while longer duration rates such as 10-year rates may head below 1%. This is not likely to be a straight-line move lower, and current declines in rates are likely have been too rapid. But as 2019 transitions towards 2020, many indicators point to an impending decline towards 0% much like in the rest of the G-10.
Is the US economy special?
Currently, the US economy looks solid on many fronts with unemployment near all-time lows and indicators such as ISM indicating optimism in the manufacturing sector. The strength in the US has been in contrast to the building weakness in Europe, Japan, China, and elsewhere, and the question is if the US can last as an island of economic strength. Maintaining this isolated strength will be needed if the US is to sustain rates near 2% even as Japanese rates rarely budge from 0%, and European rates can barely sustain above 0.5%. Most of the solid seeming economic indicators in the US are of the rearview mirror kind, especially unemployment, which only starts rising well into a slump. Indeed, the real-time estimate of GDP, which is calculated using a wide array of incoming data, is showing a rapid slowdown versus economist consensus.
The recent US slowdown is just catching up to the global synchronized weakness well underway. Looking at PMI surveys, many regions including Greater China, the Eurozone, Brazil, the UK, South Korea, Turkey, the Philippines, Canada, Mexico, Australia, Poland, and the Czech Republic have seen weakening industrial surveys pointing to slowdowns. Confirming these warning signs, interest rate curves have been heading towards inversion across countries. The US curve inversion gets much attention, but as with any indicator, a move widespread across regions is a stronger signal than a narrow move. The breadth of the global slowdown gives increasing confidence that US interest rates are unsustainable above 2% when most developed market interest rates in Europe and Japan barely hover above 0%. As is common on Wall Street, expect research teams and talking heads on TV to predict Federal Reserve rate cuts just months after boldly calling for hikes through this year.
Commodity market signals further point to the idea of a slowing, deflationary global economic picture. In recent weeks, crude oil has taken a sharp dive as geopolitical noise in the Persian Gulf has been unable to support a market weighed down by rising inventories. This weakness has not been limited to crude oil but other growth-sensitive commodities such as copper and aluminum have all declined sharply. Such a broad decline in basic commodity prices does not point to impending inflation or growth. Much more so than official government statistics, other markets are often the most timely and accurate indicators of the state of the world. And the state of the world, according to a wide range of commodities, is not great.
What about the trade war?
The trade war has been front and center with each market move lately being ascribed to the oscillations of optimism and pessimism around a trade deal with China. Our tariff addicted President has not stopped with China and will soon move on to fights with new trade partners such as Mexico or the EU. Some would claim that enacting tariffs raises the price of imported goods, which would cause inflation and hence raise interest rates. Some economists have even claimed recently that tariffs only (Most Economists See Tariff Effects on U.S. Economy as Limited, WSJ, Sep 2018). These arguments highlight a major problem with the linear supply/demand line method of viewing social systems. The argument goes something like this: “Tariffs themselves raise prices of goods worth tens of billions in a multi-trillion dollar economy, so either they cause some inflation or be contained in its effect.”
Such first-order linear analysis ignores the highly complex nature of global supply chains where each piece of clothing and each cellphone might be produced and assembled across many countries. In such highly networked, fragile systems, the reverberations of disruptions can be felt orders of magnitude larger than the immediate linear effect of the original disruptions. Indeed, disruptions to trade caused by tariffs were a contributing factor to the great depression in the 1930s, which was certainly not inflationary. The “damage is contained” fallacy was also evident during 2007 when the Fed famously believed that the subprime mortgage crisis was “contained” because only a few percents of mortgages were subprime. The reverberations from losses caused by subprime mortgages rippled through a tightly networked, fragile banking system ushering in the 2008 crisis. In a similar way, unintended consequences of tariffs may lead to a similar chain reaction causing far greater losses than the initial extra cost.
What if China sells its US Treasuries in retaliation?
China is one of the largest holders of US Government Debt with over $1 trillion of holdings. Naturally, this leads many misinformed commentators and talking heads on CNBC discussing the possibility of China dumping US Treasuries causing US rates to skyrocket and cause massive economic damage (“Trade war sparks fears of China weaponising US Treasuries,” Financial Times, May 2019). Such fears show a deep misunderstanding of what causes countries like China to purchase Treasuries in the first place and how global capital flows work. China’s holdings of Treasuries are accumulated via persistent surpluses of export earnings versus import spending as the economy is propelled via exports. Japan, an economy with a similar structure, is not coincidentally, also a major holder of Treasuries. As China accumulates excess US dollars, it can either sell these dollars to purchase domestic currency or purchase US dollar assets. Conversion to its own currency is problematic, as it would raise the value of its domestic currency and make future exports uncompetitive. Indeed, one of the loudest complaints from Washington about Beijing’s policies is that it keeps its currency artificially weak to prop up exports and this is directly maintained via huge Treasury bond holdings. Few other assets on Earth have liquidity to fulfill trillions of buying capacity, certainly not gold or bitcoins.
Even if China decides on self-harm and starts dumping US Treasuries, they are not being dumped into the void. For each seller of an asset, there is a buyer, and if we are witnessing a world where China is rapidly dumping US debt, there will be ample buyers willing to buy the safe haven asset of Treasuries. Historical evidence from previous occasions of Chinese selling of US debt such as in 2008 or 2011 saw US rates only decline. An extreme retaliation by China would cause a rapid crash in China’s own financial system, causing global economic growth to grind to a quick halt, all of which is would drive US Treasury rates much lower much like in 2008. The specter of China dumping US debt is one of the least credible threats to the US and not a valid reason to fear rising rates.
What about all our crazy debt growth?
US government borrowing comes up as another oft-cited reason interest rates could explode higher. US government borrowing has indeed skyrocketed with deficits above $1 trillion, but focusing on just government borrowing tends to be myopic when thinking about interest rates. What matters is the total supply and demand for borrowing, which includes consumer and corporate borrowing along with government borrowing. Government borrowing rising can raise interest rates if it crowds out private sector borrowing, but in the USA and other developed markets, there is a considerable excess supply of savings from an aging baby boomer population than there is demand for borrowing. Structurally this dynamic arises as borrowing demand tends to be concentrated in younger segments of the population for purchasing goods such as houses while aging workers have built up savings. This is why countries with a high proportion of youth such as emerging markets will have higher interest rates than older population ones such as Japan or Germany (with many caveats — a full discussion topic is beyond the scope of this article).
Even as overall borrowing demand is lower than supply of capital, some pockets of the economy have seen rapid growth in debt accumulation. The corporate sector, in particular, is flashing warning signs from excess borrowing such as borrowing to fund equity buybacks. Much like excess borrowing of subprime mortgages in the mid-2000s, the size of the borrowing is less of a concern than the reverberating network effects from defaults. In particular, the share of ‘covenant-lite’ loans, i.e. loans with looser repayment terms has risen sharply as a share of the total bank loan market. Such weakening of credit standards tends to appear at the last stages of a growth cycle, much like in 2006/2007. The coincident timing of an inverted yield curve, global growth slowdown, and weakening loan standards all are poor omens for future growth and point to lower Treasury yields.
When it comes to crazy debt growth, no place comes close to China. After decades of binging on debt, bills are coming due much like they did for Japan near the end of the 1980s. Complacency has been instilled through stimulus packages, bailouts, and a general aversion to defaults. Now that the Government has been cracking down on the banking system along with indicating that it will tolerate defaults, such defaults have rapidly been piling up. The real scope of bad loans in the Chinese economy is difficult to know, but it is likely much worse than the tip of the bankruptcy iceberg we have seen so far.
One may imagine that a large debt bust cause a sharp rise in interest rates in China and thus globally. However, if most of the debt defaults are in local currency, it can be deflationary as it was in Japan, with the Government likely taking on a large portion of the private sector bad debt in order to keep employment from collapsing. Such a transfer of debt sets up a deflationary trap, just in time to coincide with demographic aging, once again lining up with Japan in the late 1980s. Such events point to lower interest rates for Chinese Government debt, adding to the list of economies pressuring global rates lower.
Conclusion
In summary, many factors are pointing to declining in interest rates with US short-term rates heading towards 0 by next year as the economic cycle has likely peaked and headed towards a recession. The rest of the world, especially Japan and now Europe have laid out the path for us. Due to demographic changes and other factors pointing to economic stagnation, investing in markets will resemble the Japanese experience since 1990 far more than the more familiar experience of the US in the last few decades.
