Why debt remains the elephant in the room

“The debate on central bank policy has now shifted on to how fast and how deep interest rate cuts will go.”

Even if the committee does not cut rates today (25 July), the European Central Bank (ECB) is expected to lay the groundwork for reductions in its headline deposit and refinancing rates, as well as possibly a resumption of its QE scheme, barely eight months after President Draghi had announced a halt.

Federal Reserve and ECB are primed to cut interest rates again

Source: US Federal Reserve, European Central Bank, Refinitiv data

Financial markets currently seem happy with the prospect of this largesse. Bond markets are rallying because more QE will mean more price-insensitive buying of fixed-income instruments by central banks. This will also likely serve to drive down yields on future issuance and make the yields available on currently-traded paper look more attractive on a relative basis. Equity markets are rallying because lower returns on cash and falling bond yields may revive the ‘There Is No Alternative’ (TINA) argument for stocks, especially amongst those investors who are hungry for income.

Yet perhaps advisers and clients need to ask themselves why central banks are returning to their bags of monetary policy tricks and what potential risks lie ahead, as well as the rewards that may be accrued.

About turn

According to the website www.cbrates.com, we have had over 40 central bank rate cuts this year – with Russia, Korea, South Africa, India, Australia and New Zealand leading the way – against just 10 increases, with Norway the most prominent exponent of tighter monetary policy. That compares to 89 increases and 47 cuts last year, so the tide has turned, especially as the Fed, ECB and also Turkey have set out their stall when it comes to plans for cutting the cost of borrowing.

"We have seen over 40 central bank rate cuts this year against just 10 increases."

Gathering pace of rate cuts means the monetary policy tide has turned

Source: www.cbrates.com

Perhaps markets could have seen this coming. After all, we have been here before. A succession of central banks in developed markets – Australia, Canada, Israel, New Zealand and Sweden, as well as the EU – all raised interest rates at the start of this decade. Each nation’s central bank had to quickly backpedal and New Zealand even had another go at normalising policy without success in 2014–15.

Current policy cycle could be mirroring that of 2010-13

Source: Refinitiv data

The sextet of central banks quickly changed their minds as their currencies and borrowing costs for consumers and corporates (and governments) crimped spending, with the result that their economies slowed. It simply proved harder to move away from record-low interest rates than they had thought and central bankers have apparently come up against the same problem again in 2019.

Caught in a trap

If anything, it could be even harder to normalise interest rates now than seven or eight years ago, because global indebtedness is so much higher and no one seems to want a strong currency (which may be why gold is back on the march).

"It could be even harder to normalise interest rates now than seven or eight years ago, because global indebtedness is so much higher and no one seems to want a strong currency."

The irony is that borrowing is higher because central banks have encouraged it, with lower interest rates and QE.

According to the Institute of International Finance (IIF), global debt ended Q2 2019 at $246 trillion, or 320% of GDP. The good news is this is $2 trillion below the Q1 2018 peak in monetary terms, but it matches the all-time high of Q3 2016 as a percentage of GDP. The bad news is that global debt is now some 40% higher than when the Great Financial Crisis began. The world simply cannot afford interest rates to match those of 2006–8, when they peaked at 5.25% in the US and UK and 4.25% in the EU.

Global debt is higher than ever

Source: Refinitiv data

This raises the spectre of a Japan-style debt trap, to match the one that has devilled the Bank of Japan since 1989 – and remember that the Nikkei 225 still trades some 45% below the all-time high it reached right at the end of the 1980s, even after three decades of zero or negative interest rates and umpteen rounds of QE.

This suggests that Abraham Lincoln may have been onto something when he asserted that, “You cannot bring about prosperity by discouraging thrift”. Japan’s experiences suggest that interest rates in the West will go a lot lower for a lot longer than we expect, as central banks strive to conjure up growth and inflation by trying to encourage governments, consumers and companies to borrow and spend.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.