Our lens suggests that the very low interest rates that have prevailed for so long may not be “equilibrium” ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates.
From the BIS annual report released 6-28-2015
Low rates beget lower rates. Who woulda thunk it? Central bank policy may not be the answer but may well be part of the problem. Based on what I’ve read so far, the folks who write the BIS annual report believe that lousy monetary policy is the main problem, if far from the only one, facing the global economy. Of course, that isn’t exactly a revelation since they basically said the same thing last year. And the year before. And way back at the turn of the century and for almost every year since.
The folks down at the BIS are not known for their sunny outlook and until something changes with the way global economic policy is made that seems unlikely to change. One should consider though that BIS analysis, while not the greatest market timing tool, has the advantage of having been largely right since it first started warning about these global financial imbalances way back in the late 90s, long before it became fashionable. They were talking about secular stagnation – they didn’t have the good sense to come up with a snappy name for it – way before Robert Gordon and Larry Summers. And unlike those two pessimists they offered a reasonable explanation for it and a prescription for fixing it. Not one that anyone liked or that was necessarily political feasible but a prescription nonetheless, one that was promptly ignored and forgotten by their clients.
I won’t bore you by quoting extensively from the report; I love stuff like this but surely most of you have something better to do. Suffice it to say that the BIS, the central bankers central bank, is not particularly pleased with their monetary brethren and believe that they are fostering another round of financial imbalances that will have the same consequences as past, similar episodes. If you are an econ geek like me, here’s the link to the full report.
We’ve been writing about the low quality of the economic expansion since it started and our opinion hasn’t changed so we largely agree with the BIS which should surprise exactly no one. The drivers of this “recovery” have been weak and largely a consequence of a monetary policy that will ultimately have to be reversed. As we saw in 2000 and again in 2008, once that happens, once the policy is reversed, the boom the easy money fostered comes to an end. Then the reality of an economy suffering from low productivity growth, low investment, demographic issues and high debt levels becomes apparent and it isn’t a pretty picture. There have been positive developments over the last 6 years since the crisis – everything isn’t about the Fed – but the big picture is dominated by the activist policies of the Fed and other global central banks. And since those policies are only different in degree from the ones that created the previous two recessions, it would seem foolish to place a large wager on a different outcome.
The misallocation of resources the BIS report laments may already be starting to reveal itself in the shale oil fields where once booming North Dakota towns are starting to shrink and the layoffs are coming fast and furious. Even with prices rebounding to $60 drilling activity continues to decline. Drilling is at the front end of the energy cycle – drilling activity slows first and recovers last. There is a ripple effect as the drilling slows and affects the companies that work for and supply the drillers and so on down the line. Next will be the production declines which will mean another round of layoffs and another ripple effect. Will it be enough to cause a recession? Well, so far the effect appears to be confined to the manufacturing side of the economy but it is a bit worrisome that we got two service sector surveys last week that were both less than expected. If the service sector slows now, we may have a problem.
Stocks sure don’t seem all that concerned about a recession yet but the S&P 500 has stalled over the last six months, up only 1.6%. Small caps have done better and micro caps have done better still, highlighting the speculative nature of what rallies we have had recently. I’m on record as looking for an honest to goodness correction (over 10% but less than 20% – unless we have a recession and then probably a lot more) and I haven’t changed my mind but so far all we’ve seen is a matched contest between the bulls and bears that gets us nowhere.
The bond market, on the other hand, has been getting its long end whomped pretty regularly this year. Since the beginning of the year the yield curve has been steepening, something we normally see just prior to recession. Of course, we usually see that happening from a flat or inverted curve, a phenomenon we have yet to achieve in this cycle. And may not by the way. What’s been happening since the beginning of the year is a rise in inflation expectations while real growth expectations have barely budged from the curmudgeonly level. Credit markets, viewed through credit spreads, are also sending out pre-recession signals with spreads elevated over 100 basis points versus the lows seen last summer.
So, long term Treasury rates have risen and interest rates for credits rated lower than a Treasury have risen more – even AAA spreads have moved a bit wider recently. The Fed may not have started to tighten monetary policy but the market waits for no man or woman and it has gotten on with it. It is starting to affect the economy too. The recent surge in existing and new home sales may well be a reaction to fears of the higher rates the Fed is telegraphing, a pulling forward of transactions as buyers lock in rates and get deals done before the Fed starts to hike. If one believes in even a mild form of the efficient market hypothesis then telegraphing a policy change so far in advance must mean the policy change is fully reflected in the market well before it actually happens. Forward guidance may have unintended consequences.
Like the BIS, I believe current monetary policy is well past its freshness date. Low rates do beget lower rates and ours can’t go any lower unless we are truly headed the way of Japan where one has to look past 20 years to find a bond yield with a 1 handle. It is well past time to start considering all the other policies at our disposal and returning monetary policy to the back burner where it belongs. It appears the next election will be fought over exactly what those other policies should be and so I would not expect any policy relief until well into 2017.
In the meantime, let’s hope the BIS is again early in sounding the alarm about the consequences of lousy monetary policy. If not, one can’t help but wonder what policymakers would do in the face of another crisis or even a run of the mill recession. Not much is my guess. More QE? Seems unlikely after its obvious failure but then “nothing lasts so long as a temporary government program”. A fiscal response in an election year? Surely you jest. But that may well be the best thing that could happen for the long term health of our economy. We’re in this mess precisely because we haven’t trusted the market and have tried to do too much. Maybe a little gridlock in the face of recession would be just the reminder we need that economies do recover on their own. Nah, no one believes that anymore do they?
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or 
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