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While the main media is consumed with the economics of Bremain versus Brexit, I am going to return to the topic of ‘negative interest rates’. It’s important to understand that, whatever the outcome of the referendum, that the world of finance is already very ‘stressed’.
And as a sign of that stress, we learned this week that over $10 trillion worth of government bonds and corporate debt now carries a small negative interest rate. In other words, in return for lending money for as long as ten years, you eventually receive a slightly smaller amount in return.
To put that last paragraph into context, the annual production of the UK is worth about $3 trillion. And the interest rate on the debt means that the associated bonds are the most expensive (i.e. good for the borrower, bad for the lender) in 500 years according to some data sources.
The problem for lenders is that they are competing with the leading central banks who via monetary policy are creating money to buy those same bonds. Last week I likened this evolving policy of QE to an old rugby song with the chorus, ‘next verse, same as the first – a little bit louder and a little bit worse’.
And the little bit worse this week was the beginning of a new programme aimed at buying corporate debt by the European Central Bank (ECB).
The stated aim of the ECB and others like the Bank of Japan (BoJ) is to create economic growth and moderate inflation. But the results of QE remain mixed and they appear to need to do progressively more to achieve less. And this medicine they’re prescribing is creating significant and worrying side-effects that I mentioned in the last blog.
It’s clear, however, that their intention is to continue on this aggressive path, while also considering more radical solutions. And they have plenty of backers. The Financial Times wrote an editorial this week endorsing such moves.
And the boat of alternative strategies that some believe would have restored credibility earlier has likely sailed. The restructuring of Greece, or lack thereof, is a prime example.
Will it work?
From my perspective I can’t know. The problem is I don’t think an academic economist working for a central bank can either.
Economic theory originally drew on the early laws of physics and it has serious limitations when you compare that theory with the real world. This attempt to artificially maintain very low interest rates for a long time strikes me as more like the physicists’ concept of ‘entropy’. In other words, the more central banks seek to artificially set long term interest rates the more destabilised the system will become.
As an example, when you ‘pressurise’ interest rates in this way the only escape valve for economic reality is via the exchange rate. This isn’t such a problem if all economic areas are in the same position as, but some are better and some worse.
If we compare the Eurozone with Switzerland, economically the latter is better. But last year the Swiss central bank did not want the franc to appreciate against the euro and hurt its exporters. So it tried to create an artificially low exchange rate, which ultimately failed spectacularly on one day in March as the franc rallied 25%. I wrote about it at the time here.
Fast forward to today and the Swiss are back to square one and trying to stop the franc appreciating again. To do this they are making it less attractive to foreign investors by giving it a negative interest rate. And they’re also actively selling the franc and buying foreign assets. These assets are collectively known as ‘foreign reserves’ and are currently at the highest level ever for the swiss central bank.
China is a different story. In some ways it is worse than the EU economic area, despite the official growth figures. Like the EU, it’s trying to contain the interest cost of government and corporate debt through its own version of QE. But its overall debt levels are even higher than the EU’s and its currency has come under increasing selling pressure.
Fortunately, it already has huge foreign reserves built up via its positive trade balance with the world in recent years. And it can sell those to buy and stabilise its own currency – the opposite of what the Swiss are doing. In the last two years its China’s reserves have fallen from almost $4 trilllion to $3.2 trillion.
What to do?
So while we rightly focus in the UK on Remain versus Leave, be aware that the tectonic plates of different currency zones are under a lot of stress at various points along their edges. If any volatility in the next month gets blamed on the referendum, remember that the economic backdrop is somewhat fragile in any event and prone to sudden adjustment.
The mispricing of rates and assets also means that we have to take great care and be especially wary with any income investment strategy. This will be as true of the trustees of pension schemes as those looking to grow and drawdown income from their own pension.
And it’s not just about the risk of prices moving up and down. It’s also about liquidity risk, the ability to get to your money when you want to.
I’d add, for those of you who might have a significant foreign exchange risk now, or sometime in the future, please get in touch and I’ll explain some options that are available to you.
- past performance is no guide or guarantee of future returns;
- the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
- this blog does not constitute financial advice and is provided for general information purposes only.