Unconventional interest rate exits ahead

While some are heading for the exit from quantitative easing, others are still driving in circles

Olivier Rousseau

The financial world as we knew it ended abruptly in September, though the dangers were already well apparent beforehand. Years of extremely low central bank interest rates mixed with lax credit standards and poor bank supervision had created a combustible build-up of debt unparalleled in the history of Western economies.

In, the US subprime crisis sparked what would become the global financial crisis. But at that point, while it stressed the global financial system, it could have been contained. The problems took on a whole new dimension in September the following year when Lehman Brothers was allowed to fail.

This was a day after serial white knight Bank of America rode in to save Merrill Lynch. The rationale behind the decision on Lehman Brothers was the belief that boundaries had to be clearly defined, lest moral hazard grow unchecked. Undoubtedly the deep antagonism Lehman CEO Richard Fuld had provoked in Wall Street and Washington also played a part.

Emerging from those grim years, central banks now appear, somewhat reluctantly, as saviors of the global economyThe repercussions of allowing one major investment bank to fail were far beyond what US government circles imagined. World interbank markets seized instantly and trade financing froze. Financial markets soon fell into a tailspin and the great recession gripped. Faced with such unintended consequences, the US authorities procrastinated for several weeks before launching the $700 billion TARP program. The Federal Reserve also tried an approach that had been tested in Japan a decade earlier with little success, but which had been studied by Fed chairman Ben Bernanke: quantitative easing (QE).

Now, six years later, the Fed sits atop US Treasury bonds amounting to 20% of the GDP and another 5% or so in mortgage-backed bonds, but QE has proved extremely successful in the United States. Growth is around 3% and seems sustainable; private sector deleveraging is essentially completed; employment and consumption are growing healthily, and private sector investment is back while public deficits runs at 3% of GDP.

DRIFTING TOWARDS THE EXIT?

The Fed can now play it cool and decide opportunistically whether to roll over maturing bonds or not. But even if it rolled over all maturing bonds, time would eventually provide a clean exit from QE. If one assumes an average nominal GDP growth of 3.5% over the next 20 years, by the ratio of treasury bonds and mortgage-backed securities will have halved to a modest 12% of GDP. Another 20 years and these bonds will seem a mere curiosity on the Fed’s balance sheet.

In the United Kingdom, the situation is similar. The Bank of England’s QE, launched in March, helped push down long-term interest rates. Growth has returned, though it seems more fragile as it relies on renewed property market exuberance – as well as accompanying indebtedness.

STUCK IN ROUNDABOUTS

Despite initiating the first QE program back in, Japan had seemed a perennial basket case. Stuck in economic doldrums with endlessly growing public debt, QE failed to lift Japan out of deflation. When, at the end of, Prime Minister Shinzo Abe launched a further massive QE program as part of a set of policies designed to help Japan break free from two decades of on-and-off deflation, he was met with considerable market skepticism.

Yet, although GDP figures failed to support the positive results of, largely owing to a 3% increase in the VAT rate, “Abenomics” has brought a dramatic change to Japanese state solvency, boosted equities and had a profound effect on industrial prospects. But regardless of whether Abenomics works, the question will remain: how can Japan ever exit QE? The Bank of Japan (BOJ) has bought enormous amounts of public debt since April and holds Japanese government bonds (JGBs) worth close to 30% of GDP. It is well on its way towards doubling this, an amount that will be close to half of the net outstanding debt of the Japanese state – and inflation is still subdued.

There is already massive and rapidly expanding public debt monetization by the BOJ. Given that the nominal growth rate of the Japanese economy will probably remain around 2% annually, time will hardly help erode this debt, but the lack of inflation means that the BOJ can simply sit on its position.

Maybe in a decade it will be realized that these holdings still have not translated into inflation and eventually a conclusion reached that those JGBs do not need to be reimbursed. Thus, de facto long-term debt monetization will then become permanent monetization, and all that without inflation flaring up or public trust in the Japanese currency eroding.

Late to take action, the European Central Bank (ECB) only recently commenced a QE program, but did so with a boldness that surprised the market and pundits. The woes of the great recession and the eurozone crisis have considerably weakened European countries, however. Even with the low interest rates with which peripheral countries are now financing themselves, it will not be easy to lower debt-to-GDP ratios. When the next recession inevitably strikes, some countries will find themselves with unsustainable debts.

Despite the large sovereign bond purchases by the ECB and the corresponding ballooning of the eurozone monetary base, inflation will probably remain contained. As the ECB will not be able to sell the bonds, the context of tamed inflation means a dose of permanent debt monetization will be the outcome, even though it was not envisaged at the onset.

RELUCTANT HEROES

Central banks played a major role in the formation of the credit bubbles that led to the financial crisis because they failed to take away the punch bowl once the party became riotous. But since the onset of the crisis, they have been the main players stabilizing the financial markets and economies.

Emerging from those grim years, they now appear, somewhat reluctantly, as saviors of the global economy. Their actions prevented systemic failures by financial institutions and massive sovereign state defaults. But as they plot their exit policies from or continue to navigate the path of QE, central banks face the perils of economies and financial markets addicted to low interest rates.

Normalizing interest rates will be the next global challenge. Equities still offer reasonable returns, but almost all other asset classes have been beaten down by the relentless hunt for yield that zero-interest- rate policies have ignited. Sovereign bonds are currently abnormally low, credit spreads compressed, property and illiquid assets expensive. Even the current artwork investment mania shows how distortions emerge when the price of money is kept artificially low.

Unconventional interest rate exits ahead

While some are heading for the exit from quantitative easing, others are still driving in circles

Olivier Rousseau

Unconventional interest rate exits ahead

While some are heading for the exit from quantitative easing, others are still driving in circles

Olivier Rousseau

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