“Round about the cauldron go;
In the poison’d entrails throw.
Toad, that under cold stone
Days and nights has thirty-one
Swelter’d venom sleeping got,
Boil thou first i’ the charmed pot.”
In William Shakespeare’s opening scene to the play Macbeth three witches toil away at a poisonous cauldron, awaiting the arrival of the prophesied King.
Today Draghi, Carney and Yellen dance around a cauldron of low interest rates and quantitative easing – a poisonous stew of low yields. The target is modest inflation, however reaching this ‘throne’ has unsettling consequences for both credit and stock markets.
Let’s look at the situation. Since 2008 base interest rates have been kept at the lowest levels on record. The Bank of England (BofE) is currently at 0.25 per cent, European Central Bank (ECB) at 0.00 per cent and The Federal Reserve (Fed) at 0.50 per cent.
Base rates were lowered following the financial crisis to help boost economic growth. Lower base rates are passed onto the consumer through the retails banks in the form of cheaper loans and less interest on savings accounts. This combined effect increases spending, and thus the demand for goods and services, resulting in inflation and higher gross domestic product (GDP). Inflation is key, as this is the central bank’s target.
In 2008 central banks recognised that base rates may not be effective as a singular tool, especially considering the sheer scale of the crisis. They introduced asset-purchasing programs, known as quantitative easing (QE). In this case central banks use their power of creating money to purchase government bonds from investors, increasing bond prices and thus lowering yields*
*If a bond is worth £100 and pays a £10 coupon, its yield is 10%. However when the price of the bond increases to £110 its yield with the £10 coupon is now 9.09%.
Investors have cash in their pockets from the sale of their bonds, and this is used to invest in riskier assets, such as stocks, that are now more attractive due to the lower yield on government bonds and on retail savings. A lower yield encourages investors who didn’t even hold bonds in the first place to purchase riskier assets. This is why you see the stock market rally when additional QE is announced, and is precisely what the central banks want because riskier assets are in low demand following the financial crisis.
It’s this investor hunt for yield that is worrying. In the quest for inflation the three witches have manipulated Macbeth into murdering government bond yields. Macbeth now sets his sights on the credit and stock markets.
The credit market.
In the immediate aftermath of the Brexit referendum the pound sterling lost 15 per cent of its value, falling from approx. 1.5$/£ to 1.3$/£. This loss in value is attributable to uncertainty over Britain’s economic future leading investors to sell their GBP denominated investments. By deduction we would also expect government bonds to be sold off and their yields to increase, because slower economic growth means less income from taxes, which lowers the capability for the government to pay back its debt. However UK government bonds haven’t seen their price fall, or their yields rise. In fact quite the opposite has occurred. The UK 10 year gilt yield has fallen from 2 per cent at the beginning of the year to nearly 0 per cent.
The currency markets are telling us “flee the pound, UK economic growth is slowing down”, whilst the bond market is telling us “pile into UK government debt, their economy is strong”.
Remember the cauldron? In the case above Mark Carney has thrown in another bout of asset purchasing, which has fuelled further overvaluation of the credit market. The UK central bank has artificially boosted the demand for Gilts, even though fundamentals suggest the opposite should be occurring.
The stock market.
Another piece to this bubble is the stock market. As we mentioned earlier QE encourages investors to search for yield. Last week stock markets hit new records, yet the UK and U.S. still remain in economic stagnation. In my eyes this is a clear detachment from fundamentals, the stock market is being driven by cheap credit and QE. Why does this matter? The market will eventual correct itself and the bubble will burst.
Retail bank defaults.
To make things even worse let’s add the risk of retail bank defaults into the cauldron. Share prices in major European banks have fallen between 20 and 40 per cent in 2016. The two main causes of this have been low base rates reducing the profitability of their loans, and the sudden collapse of oil from $110 to $28 over a one-year period, which has led to an increase in non-performing loans from the energy sector. A falling share price reduces the capital available to banks, and if the banks collapse then lending stops and the economic grinds to a 2008-style halt.
The wake up moment for me was in December 2015, when the Fed raised their base rate from 0.25 per cent to 0.5 per cent. Shortly following that decision there was a massive sell off in the high yield “junk” bond market. These are bonds that investors have been arguably forced to buy because the yield on other governmental and corporate debt is too low. Rates only increased 0.25 per cent and the market had a panic attack, in my eyes this is a stark warning that the markets are teetering on bursting.
Fundamentally our economies cannot remain propped up by QE or low interest rates; they must function on their own two feet. The problem is that a rate rise exposes the reality of a deep detachment between economic fundamentals and the price of bonds and stocks. The muscles holding up our feet no longer function without central bank assistance.
Give the legs a workout. Raise rates, now. Take a hit and rid the economy of some of the junk, like we did in December 2015. The longer we mill around in this credit bubble the worse it gets. Investors become more complacent and pile into overvalued stocks, whilst bad debt is accumulated as investors continue on a desperate quest for yield. Banks fail and pension funds fall into deeper deficits. The inevitable economic fall out from ‘normalizing rates’ can be eased with accommodative fiscal policy – lower taxes, greater structural spending. We’re going to have to take the tough medicine at some point and I’d rather take it now, than risk larger issues down the line.
Further reading on this topic: