There are many who argue that current low world interest rates will continue indefinitely. That goes for short rates as well as long rates. They argue that the weakness of the world economy, weak demand for funds, high savings and/or deflationary forces will keep interest rates low.
I disagree. To me, that sounds more like an explanation of why interest rates are low now than a reason for them remaining low into the future. My belief is that low world interest rates are unsustainable.
My comment is that current circumstances tend to dominate thinking as we work our way through the uncertainty of economic events. Economies take time to change, and the circumstances that have led to current low interest rates will change as, gradually, the impact of the global financial crisis (GFC) recedes.
The GFC was a major correction following the preceding debt-driven boom. Monetary authorities introduced extraordinary measures to counter the threat or reality of recession, including extremely low interest rates and quantitative easing (QE). Given the magnitude of the correction, it was always going to take a long time to get through its consequences.
We have to wait for these cyclical shifts to run their course. In particular, we can’t expect a resurgence of investment until economies have absorbed the excess capacity created during the debt-driven boom that preceded and caused the financial crisis and recession.
Stimulate weak growth
We are still in the phase where monetary authorities are looking to stimulate weak growth, but that can’t be sustained. Already, readily available low-cost funding has stimulated asset markets around the world.
Low interest rates have driven yield-seeking investors to look beyond bonds into other asset classes. And low interest rates encourage investors to gear up to improve the return on equity. Have we so soon forgotten the logic of the financial engineering boom that triggered the GFC?
Moreover, higher asset prices improve financial feasibilities on investment projects, which drives the spread from asset markets to real investment, prematurely stimulating, accentuating and hastening investment cycles. That’s okay for now. Some investment stimulus is welcome from the point of view of boosting demand. But the other side of the coin is that it brings forward and exacerbates the magnitude of the next downturn. There are medium-term consequences for the stability of growth.
Most monetary authorities know this. They would prefer steady growth to large cyclical swings and will run monetary policy accordingly by raising interest rates as markets strengthen – particularly given the recent memory of the last cyclical episode.
Weight of money
Meanwhile, the problem is that weight of money associated with the inflow of funds can cause overvaluation of assets. That’s already a concern in many asset markets where price/earnings ratios and yields have firmed ahead of income.
I think interest rates will rise. It will start in the US where the Federal Reserve has already flagged that the strengthening economy will lead them to raise short rates.
Australia won’t automatically follow. The high differential between Australian and US interest rates will allow the RBA to target domestic policy objectives. And they would welcome the effect of a lower differential on the Australian dollar. That will keep the Australian cash rates, bill rates and variable mortgage rates low for some time yet, even after US rates rise.
More importantly, the rise in US short rates will trigger a rise in bond rates. Later, recovery in investment, growth, and hence the demand for funds will chime in, leading to further rises in bond rates. And, given Australia’s current account deficit and the need to refinance existing loans, that will flow on quickly to Australian bond rates. It’s hard to pick the exact timing, but I expect bond rates to be substantially higher in two years’ time.
That raises the question of what happens to asset prices when interest rates, and particularly bond rates, rise.
Prices ahead of income
In Australia, weight of money has driven prices ahead of incomes. Equity and property yields have firmed ahead of corporate profits and leasing markets. Prices have been driven by investor demand, but my observation is that
the magnitude is relatively limited.
For example, property markets are only slightly overvalued. Hence I expect only a moderate correction as interest rates rise.
That is, assuming that interest rates rise. Given the current stage of the debate, we need to recognise that we are taking a position on future rates. And that will have more influence on returns to bond-market investment than on other asset classes.
In normal circumstances, further rises in asset prices would have to be driven by incomes. But incomes have to date been subdued.
Meanwhile, the Australian economy faces extraordinary cyclical and structural shifts, which will dominate the course of incomes. However, the current mistake by many investors is in not differentiating between markets, leaving some overvalued, some undervalued and others reasonably valued. Some will rise and others will fall dramatically as structural shifts and investment cycles run their course. The different cycles in both property and equity markets are out of sync. Each needs to be evaluated on its own merits.
The upshot is that there are few real bargains in investment markets. Future price rises will need to be driven by strong incomes. And there are cyclical risks in some markets. Where incomes fail to rise – or in some cases, where incomes fall – prices will correct. That makes allocation difficult. There are good returns to be had, but there are cyclical risks both on the downside and the upside. The next few years in investment markets will be tricky to navigate.
