The era of low interest rates is drawing to a closeby Jonathan Underhill
Henry Kaufman, the former Wall Street insider once known as Dr Doom, predicted the longest-ever decline in interest rates in bond market history in 1982. Now he’s back to tell us it’s over.
In mid-1982, before Kaufman forecast the bottom of the market, the interest rate on the benchmark 10-year US Treasury bond was 14.5%. In early July, the yield was 1.37%, a level that may prove to be the low point.
For the uninitiated, bonds appear back-to-front. The lower the interest rate, the more valuable the bond. When rates start rising, bondholders start losing money.
Since Donald Trump’s election victory on November 8, the yield on 10-year Treasuries has jumped half a percentage point to a 16-month high. If Kaufman is right, and many financial market participants agree with him, this is a historic moment.
“Secular [long-term] swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards,” Kaufman told the FT.
In New Zealand, the Reserve Bank has said much the same by projecting virtually no more cuts in the official cash rate, now at a record low 1.75%, even if increases don’t start for a couple of years.
“A lot of people are saying we may have seen the bottom in the global interest rate cycle,” RBNZ deputy governor Grant Spencer said after the release of the bank’s financial stability report on November 30.
The key is that inflation has bottomed in many major developed countries. If the RBNZ is right, inflation is also picking up here, and will reach an annual rate of 1.1% in the final quarter of 2016 after undershooting its 1-3% target range for more than two years.
Wellington-based Harbour Asset Management, which oversees about $1.1 billion of fixed-income investments such as bonds, recently posed the question whether a “great investment rotation” was under way. The Harbour team argued that over the medium to long term, if inflation has bottomed out, “this justifies bond yields rising from their post-financial crisis lows, and within equities this favours growth over equity income”.
Harbour’s head of fixed-interest investing, Christian Hawkesby, says with Trump “there’s a potential for a new narrative – cut tax, spend on infrastructure, all those things that are inflationary. Then the question is how far can that run.” There are still global forces acting as a counterbalance, such as loose monetary policy in the eurozone and Japan.
The US Federal Reserve has spent US$3.5 trillion on quantitative easing – or printing money – since the financial crisis. The European Central Bank and the Bank of Japan, still facing some risk of deflation, have dabbled with negative interest rates – where the lender pays the borrower.
“Central bankers can’t be always trying new things. It causes problems for savers and pension funds,” says Hawkesby, who was working for the Bank of England when the financial crisis hit. “It gets to a point where capital markets stop sending signals of what’s a good investment, what’s a bad investment, because everything is distorted.”
Hawkesby, who began his career at the Reserve Bank, says central banks can be as much in the dark as the rest of us about the state of the global economy and how monetary policy should respond.
“They are human like the rest of us. They don’t have all the answers. Policy is going to be dependent on the way things pan out.”
Which way the wind blows
Kiwi investors and home-owners are just starting to feel the winds of change. Term deposit rates remain low – a two-year term was paying about 3.4% early this month compared with about 4.7% in 2014 and as much as 8.24% in early 2008, according to interest.co.nz. A two-year fixed-rate mortgage at about 4.5% is up about 15 basis points from its lows of May and June this year but much cheaper than in August 2014, when 6.35% was on offer.
Philip Borkin, senior economist at ANZ Bank, says a sense of perspective is needed on what happens to interest rates from here. A “neutral” level for rates, at which they are neither stimulating nor holding back economic growth, is probably about 3%, he says. That suggests they won’t return to anywhere near as high as their 1980s levels, when mortgage interest rates were 20%-plus.
“[Low] interest rates are stimulatory in New Zealand, no doubt about it,” Borkin says. “But they may not be as stimulatory as was once the case.”
Some members of the Federal Open Market Committee, the policy-setting wing of the US’s central bank, have indicated it would not take many hikes to get US interest rates back to neutral, including the increase expected on December 14.
“Maybe now is the time to be fixing [mortgages] for a little bit longer,” Borkin says. “But the global economy is far too fragile” to suggest interest rates will soar from here.
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