On A Cross Of Bonds (An Interest Rate Is A Price)

The goal of quantitative easing was to keep interest rates low so households and firms would go out, borrow money and spend like there is no tomorrow.

Because consumption drives the debt fuelled economy, central bankers around the world were happy to crucify price signals in the form of interest rates that reflect risk and the time value of money on a cross of bonds.

One of the most basic concepts in economics is diminishing marginal returns. When you consume more of something, you get less and less satisfaction until some point where you’re getting negative utility from consuming more of it. I think that quantitative easing has hit diminishing returns and no there is nothing central banks can do in order to restore valid price signals in the form of interest rates.

Just like an exchange rate is a price, an interest rate is a price. It’s a price of how much it will cost for us to bring consumption forward to today. It’s an exchange rate across time. By keeping interest rates low, central banks were trying to change the way we thought about borrowing for more consumption today to be repaid with interest tomorrow. Even firms have been paying down debt and returning cash in dividends or buybacks.

But the household balance sheet restructuring of the past few years has changed something. Private sector demand for credit has declined. The velocity of money is low so that monetary base ain’t going anywhere than financial institutions balance sheets. Sure, we’ve got a resurgent housing boom, but there are big supply side backlogs that need to be cleared in New Zealand. Banks will lend to home buyers, but they won’t lend to builders or developers.

When you realise that banks get a decent proportion of their funding on the wholesale money markets, where the rates they’ve been paying have been artificially low since the GFC hit, and then realise that macro-prudential tools just introduced by the Reserve Bank and Basel III mean that banks need lower reserves for housing lending than they do for business lending, you’ll get some sort of idea of how stuffed we are when rates rise.

An interest rate is a price, and one of the reasons the financial markets are producing dramatic movements is that investors are trying to sort out whether the recovery is real or if it’s just the response of people whose preferences have been twisted far enough by central banks to make them willing to lend or willing to buy bonds that they wouldn’t have touched a decade ago.

An example of this is high yield corporate bonds in the US – also referred to as junk bonds. These low rated bonds that are very risky in terms of default potential have reached yields as low as 5% in the past few months. When there is a speculative reach for yield, anything with a yield will do as long as it has some sort of rating attached.

One of the problems with central bankers is that they live in a bubble. In their interactions with the financial community, the media, the corporate executives they meet at conferences and the people who sit next to them in private jet terminals and airport lounges around the world – quantitative easing is doing wonders for their household net worth.

But the problem of living in a bubble is that for pretty much anyone who does not own a substantial amount of assets, the economy sucks. Household wealth has gone down for most people, with tarnished credit ratings they can’t borrow even though they might have a good cheap business idea. That means that quantitative easing can only succeed if the banks pass on the implicit subsidy they’re getting from everyone else in the world.

Inflation has not emerged like some said it would. That’s because although the monetary base has expanded dramatically, velocity of money has declined – even plummeted in some economies. After Cyprus, people are aware that a bank deposit is an unsecured deposit and it’s not yours. This means that moving from cash into anything but a bank account pushes asset prices even higher.

How does this all end? Well, if interest rates rise suddenly, enormous capital losses are imposed on bondholders. The mantra of the global financial crisis has been “Thou shalt protect the bondholders” – same for the Wall Street bailout that used AIG as a conduit. How leveraged have hedge funds been in taking advantage of QE? How bad will the margin calls be? How will the prime brokerage desks handle a potential repeat of 1994?

I don’t know, and am smart enough to realise that at this point, the most honest thing economists can do is tell the truth. The central bank playing around in ways that were never conceptualised at the outset of monetarism has opened a whole new can of worms. Using the S&P500 as an indicator of economic performance does not lead to broad prosperity.

When the central bankers want to sacrifice everything on a cross of bonds, the demand for physical assets and financial assets that will benefit from inflation is clear. There’s a demand side story on top of the monthly bond purchases by central banks around the world. And if the fundamentals improve, who knows where asset prices could go?

The Risk Free Rate Of Return

The risk free rate of return is the rate of return an investor could earn with “zero risk”. Since the global financial crisis and Asian financial crisis, we’ve been reminded constantly that there is no such thing as “zero risk”.

But the risk free rate of return is useful for comparing the rate of return other assets earn in relation to it. There is no point taking enormous risk to earn a slightly higher return than you could get from government bonds.

The standard global “risk free” rate of return is the 3 month US Treasury bill rate. For New Zealand investors, we could use the 90 Day Bank Bill Rate. As of writing that’s 2.71% on an annualised basis.

That means that if we wanted to lower our private sector risk and rely on the government, and had access to the institutional money markets, we could make 2.71% a year with low “risk”.

The problem with this sort of thinking is that it uses one metric – the “risk free rate of return” – as a decision making tool. The other risks your investment will be exposed to can be ignored.

For example, during the Asian Financial Crisis, many governments defaulted on their sovereign debt. This was in 1997. Attracted by high yields and assuming that governments would always pay their bondholders back, investors piled into markets in Thailand, Malaysia, Indonesia, Korea, Russia, Argentina and Brazil.

Many were heavily burned by forgetting that some countries have completely different attitudes towards debt repayment. Look at Greece – it has survived in the euro zone so far only because hundreds of billions of Euros has been transferred to it by other member countries.

It would have been cheaper for the Eurozone to underwrite Greece’s structural deficits since it entered the Eurozone fraudulently. At least then the true picture of the Eurozone’s complete failure to pursue balanced budgets would have been there for the world to see.

Because the common currency established a central “risk free rate of return” available from the European Central Bank, it effectively subsidised the interest rates payable by poor governments in Greece, Portugal and Spain.

Ratings agencies and investment banks papered over the enormous problems in the European economies to enable continued debt issuance and debt rollovers that failed to address the sick problems in their economies.

Even Germany has enormous external debt to GDP because it has pursued expensive social policies while reforming its economy and lowering labour costs. France has failed to lower labour costs and improve competitiveness, making it an economic zombie doomed to default at some point in the future.

The problem with financial theory is that its proponents will argue that concepts like “risk free rate of return” don’t lead to bigger problems when applied on a global scale. That’s patently false.

If financial theorists didn’t pollute the world with their fake models and theories better suited for the complexity of a village cattle market, groupthink – an entire industry thinking that government debt has little to no risk – would not have occurred on a scale this bad.

Coming back to the risk free rate of return in New Zealand, it is unlikely that New Zealand would default on its debt. But we have no idea about what could happen to New Zealand’s economy over the next decade.

Treasury and Reserve Bank predictions are relied on by the government to conduct “long term budgeting”. All of the predictions are wrong. All of the predictions are arrogant. We would be better off if they came clean and admitted – we can’t predict the state of government finances and when we’ll return to surplus.

As an example of the poor thinking behind these forecasts, cast your mind back to 2008. The National government engaged in “fiscally neutral tax cuts” that cut personal income tax and raised GST simultaneously.

Funnily enough, all that happened was the loss of billions of dollars in tax revenue over the past couple of years. When you add in the cost of the Christchurch earthquake, that’s billions of dollars in extra borrowing the government has taken on.

Forecasts for tax revenue have consistently been revised downwards. That’s because we’re in the stage of a multi-year recession where companies who have been trucking along suddenly default on all of their tax obligations. Even though IRD can be secured creditors, if there’s nothing in the entity they don’t get a dollar.

We need to move away from messy thinking about risk and reward. Using the risk free rate of return is insane in an era where we really have no ability to predict which government will be at risk of default next. The past few years have surely shown us that what finance academics think is clearly not in touch with this thing called “the real world”.

I’d appreciate your comments on this. Do you think that economists and financial “experts” are living in a fantasy world?