Less Than Zero

Investment Note #14 - 31st May 2024

Less Than Zero

Synopsis

• Markets are forecasting that interest rates will come back down as soon as inflation is tamed. However, we should consider - what’s the need to rush back? It seems that some market participants are experiencing collective withdrawals as the era of easy money has come to an abrupt end. This Investment Note will explore how we got there, the impacts it had and the reasons we shouldn’t rush back.

• The last holdout, the Bank of Japan, recently bumped its key policy rate positive, a move that marks the end of the 13-year unconventional monetary strategy and even if only temporarily, a return to the long-term normality.

• The Federal Reserve and ECB kept money free for nearly 13 years through their near-zero interest rate policies. The period from 2009 to 2022 was characterised by modest growth, higher market concentrations, reduced productivity and excessive risk-taking.

• Over the past two years, the Fed and ECB have rapidly hiked rates to 5.5% and 4.0% respectively, a transition that feels alien to many businesses, consumers and governments.

A Brief History of Interest Rates

• In its simplest form, interest is the price a borrower pays to a lender. Interest rates reflect the relationship between time and money in an economy.

• Its roots trace all the way back to ancient Mesopotamia; the Babylonians were charging fees on their loans long before they discovered how to put wheels on their carts. Far before coined money, ancient societies were charging interest on crop and livestock loans.

• The Babylonians Sumerian word for interest was ‘mas’, which signifies a lamb - the fruit of the loan. The Babylonian’s loans and interest system evolved to be structured; records were kept on clay tablets, regulators regulated the system and interest rates were set by the ruler.

• The level of interest tended to be anchored to the productivity of agriculture; before modern times this tended to float around 5% - 20% (Source: The Price of Time, E. Chancellor).

How We Landed at Rock Bottom

• Through the 20th century, the management of interest rates emerged as the primary weapon in the arsenal of central bankers. Lowering interest rates facilitates easier access to money, thereby stimulating economic activity.

• After the Great Depression central banks began to cut rates to protect markets from deep or prolonged recessions. This trend accelerated over the past c.40 years as we’ve seen a fall in the Fed rate from a peak of 19% in 1981 to 0% in 2020, a trajectory that loosely follows the path of a downward staircase as the Fed reacts with cuts to each downturn. While rates have increased, they rarely return to the pre-cut level.

• The ECB followed a similar trend. The ECB’s rate peaked at 4.75% in late 2000. Post Financial Crisis this was cut to 1.0%, however, as the Eurozone continued to struggle over the following few years, the ECB did what many economists warned was too dangerous and cut the deposit facility rate to -0.2% (where Banks deposit their excess liquidity).

• There were warnings at the time that this action would lead to mass bank runs as consumers could get better value by ‘depositing’ cash in their mattresses (or other international banks). While that didn’t specifically materialise, economies did suffer in other ways.

Structural Challenges of Low Rates

• Liquidity Trap: In 1936 John Maynard Keynes (known as the father of modern macroeconomics) spoke of the ‘liquidity trap’ when describing the limits of low interest rates as an effective policy tool. Keynes proposed that when rates hover near zero, savers become unresponsive to rate changes, leading to static demand and prolonged economic stagnation.

• Ballooning Debt: Lower interest rates encourage borrowing, leading to consumer, corporate and government debt growing to unprecedented levels. Japan who has had near zero rates since 1995 has a government debt to GDP of over 250%, the highest in the world (Source: OECD). Such levels of debt can widen inequality and put a heavy strain on an economy’s resources.

• Zombie Companies: Moreover, cheap borrowing boosts the number of zombie companies -insolvent businesses that can only pay loan interest but not the principal. These companies harm society by wasting skilled labour and reducing economic productivity. In 2001, over 15% of listed firms in Japan were zombie companies (Source: The Economist).

• Creative Disruption: The ongoing need to support economies and businesses undermines a crucial aspect of a market-driven system: the necessary elimination of inefficient, sluggish businesses to force innovation and sprout new companies.

Down the Risk Curve

• Negative interest rates chip away at deposits, forcing investors to stretch for positive yields.

• In theory, this money first flows into assets like bonds, however over time the mass of inflows pulls down the yields. A record US$17 trillion worth of government bonds in August 2019 had negative yields. Money then flows into riskier and riskier assets.

• A similar concept was seen in corporate investing - a fundamental concept in valuations is that money is worth more today than in the future. However, in a zero-rate environment, this concept falls apart - which in essence means there is no hurdle for investments. This prompts corporations to justify investments in overly risky projects with low returns.

The Everything Bubble – Things Got Strange

• All this combined resulted in the speculative markets that we’ve seen over the past decade. Is it any surprise that multimillion-dollar NFT monkeys and a $90 billion dog-themed cryptocurrency came about in this era?

• The SPAC fad in 2020 and 2021 is an example of this. Over the two years, investors poured billions into SPACs, which are publicly listed shell firms with the sole intent of merging with a private company.

• At the time, even a loose mention of a potential merger between a SPAC and an exciting private company would send a blank cheque stock soaring. The most notable SPAC merger involved WeWork, which was done in an effort to rescue the struggling company. Despite raising $1.3 billion at a $9.0 billion valuation, WeWork’s stock has since lost -99.9% and is undergoing Chapter 11 bankruptcy. According to Bloomberg, there are over 23 bankrupt SPAC companies, and around 110 SPAC firms are trading for less than $1 today.

Summary

• Given the side effects of ultra-low rates – asset bubbles, inequality, and financial fragility – is it wise to rush back? US rates are currently at 5.5% and markets are pricing in two rate cuts before the end of the year, down from seven at the start of the year.

• After recent financial wobbles, marked by the collapse of SVB and Signature Bank, businesses are slowly adapting to higher borrowing costs. This is an opportunity for central banks to establish a more sustainable interest rate level, promoting healthier markets and a more balanced risk dynamic.

• As we approach a turn in the interest cycle, which will likely be prompted by the ECB at next Thursday’s meeting, it warrants some reflection on what the desired destination is. Looking back at the last decade – do central bankers really want to go back to rock bottom?