Winter is coming

Could the fall in interest rates result in an economic ice age for western economies?

By Cormac Lucey

Across the developed world, interest rates have collapsed over recent decades. Yields on German government 10-year bonds fell below -0.7% this month while yields in Japan were hovering at -0.3%. Japan has struggled to combat low growth and low interest rates for 30 years. Only America, where rates on government bonds remain at about 1.6%, has avoided Japanification. So far. The trouble is the US may be headed that way too – its rate has halved since last October. Why have interest rates fallen so far, and where might they now be headed?

Several factors influence underlying interest rates. The first is the rate of inflation. In theory, real interest rates (after we exclude the inflation factor) should be relatively stable. So, if inflation drops sharply, we would expect a sharp drop in interest rates. And inflation has indeed dropped sharply in western countries over recent decades since it peaked in the inflationary 1970s.

Nonetheless, in recent times real interest rates have also dropped. It used to be the case that bank depositors got a rate of interest that exceeded the rate of inflation and provided them with real capital appreciation. That is no longer the case. Today, depositors get negligible or nil rates of interest income even though inflation persists and erodes the underlying value of their savings. There are other factors at play.

The biggest cause of ultra-low rates is weak economic growth. If growth rates are high, there is substantial demand for investment funds which stokes demand for deposits (so that banks will have sufficient funds to lend) and supports higher interest rates. Low economic growth pushes interest rates down. Over the twentieth century, productivity per worker grew in the developed world at about 2% per annum. Since the turn of the century, underlying growth amounts to half or less than half of that rate. This problem has been described as “secular stagnation”. There has been extensive academic debate on the subject, but nobody has come up with a convincing explanation for this drop in underlying economic growth.

Ageing populations are another factor propelling interest rates downwards. The longer we anticipate our life after retirement will be, the more we need to save to fund our retirements. If the supply of savings increases then, all other things being equal, we would expect the price of savings (i.e. the rate of interest) to fall.

There are several problems with interest rates being this low. Central bankers have less interest rate-cutting ammunition with which to fight the next recession. It is notable that the European Central Bank is already contemplating monetary policy relaxation to fight the next downturn without having once felt able to increase its base rate of interest during the economic recovery since 2010.

Commercial banks also have big problems as a significant element of their profits – interest income generated from current account deposits on which they pay no interest – has dried up in today’s low interest rate environment. That helps explain why the index of euro area bank equities has fallen in value by over 40% since January 2018.

Albert Edwards, a strategist with the French investment bank, Société Générale, has long predicted this fall in interest rates and an economic ice age for western economies. He recently asked: “Do market participants really believe fiscal stimulus and helicopter money will save us from a gut-wrenching global bust that will make 2008 look like a picnic?” He argues that the current government bond rally is not a bubble, but an appropriate reaction to the market discounting the next global recession. This means that “the bubbles are not in the government bond market in my view. They are in corporate equities and corporate bonds”. Ouch!