The Paradox of Low Interest Rates

Wednesday, 16th March, 2016
Albert Park, Australia
By Kris Sayce

  • As iron ore falls, so does this
  • Avoiding one ‘problem’ creates another
  • And on it goes…

We are relatively bearish about the iron ore price, probably more bearish about the iron ore price than the price of any other commodity that is currently part of the BHP Billiton portfolio.

And so were the words of BHP Billiton Ltd [ASX:BHP] chief executive officer, Andrew Mackenzie.

Investors who bought at higher prices, and those who bought at lower prices, hoping for a continued rally, probably wish Mr Mackenzie had kept his mouth shut.

But we’re not about to berate a CEO for daring to tell the truth. We rather like it. But then, we don’t own any BHP shares…or any other iron ore producer for that matter.

At the time of writing, the BHP share price is $16.68, down 2.6% from yesterday’s closing price. The iron ore price is trading at US$52.88, down US$2.67 on yesterday’s price.

Is the iron ore price heading back to the December 2015 low, below US$40 per tonne? Maybe. Maybe not. The recent spike above US$63 was clearly excessive.

Arguably, the slump below US$40 was excessive too. After all, from the peak in 2011 to the trough last year, the price had fallen over 80%.



Source: Bloomberg
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From the perspective of a five-year view of the iron ore price, the recent spike looks like nothing of consequence. Certainly nothing that should cause any iron ore producer to become overexcited.

We can only wonder what the executives at Fortescue Metals Group Ltd [ASX:FMG] have to say about the iron ore price? Are they quite as bearish as BHP’s executives?

We’ll await their comments with interest.

As iron ore falls, so does this

In related news, at the time of writing, the Fortescue share price is down nine cents, or 3.5% for the day.

Where the iron ore price goes, the Fortescue share price follows.

Markets

Overnight, the Dow Jones Industrial Average staged a wonderful rally. It opened down 0.6%, but climbed all day, to close up 0.1%.

The S&P 500 performed similarly, but couldn’t quite make it into positive territory. It closed down 0.2%.

Earlier in Europe, the Euro Stoxx 50 index closed down 0.8%.

The FTSE 100 index closed down 0.6%, while the German DAX index closed down 0.6% too.

In local markets, Japan’s Nikkei 225 index is down 0.4%, while the Aussie S&P/ASX 200 index has fluttered between positive and negative all day. At the time of writing, it’s down just 0.06%.

As for commodities, West Texas Intermediate crude oil is trading for US$36.93 per barrel, and gold is trading for US$1,233 per ounce.

Avoiding one ‘problem’ creates another

Even if you only subscribe to a couple of our investment advisories, you’ll know that we publish a lot of ‘stuff’.

In fact, even our top Alliance members (who love what we do) say that their single gripe about the Alliance membership is the sheer quantity of the material they receive in their email inbox.

However, even though I know we publish a lot of stuff, as the publisher, I don’t regret it for a moment.

That’s despite knowing that it isn’t always the best it can be. I know from personal experience that, from time to time, I ‘mail it in’. By that I mean it’s not my best effort.

And I’m certain my colleagues occasionally feel the same way about some of the things they send out too. That’s not knocking them or me; it’s just part of the territory of producing regular market commentary on a daily, weekly, and monthly basis.

But after writing yesterday’s Port Phillip Insider, it helped remind me why I’m fine with us publishing so much material.

Because, sometimes, it’s only by thinking constantly and writing prolifically that everything becomes clear. Without that daily deadline (and dare I say it, the daily grind), some of our best thoughts may never make it onto the page and into your email.

(Arguably, of course, some of our worst thoughts may otherwise never make it onto the page and into your email too. So, sorry about that!)

To refresh your memory, we repeat the final paragraphs of yesterday’s Port Phillip Insider:

If wages aren’t growing, why should borrowing increase?

It shouldn’t. This is the paradox of low interest rates. Far from encouraging people and businesses to borrow and spend, they appear more likely to save and save.

That’s why central banks have to print more money, and why they have to cut interest rates further. It’s not to benefit the consumer. It’s to benefit the government, so it can borrow and spend in order to try to prevent the inevitable economic collapse.

We thought more and more about this on the long drive home yesterday evening.

Central bankers and governments can’t understand why people and businesses won’t spend. They chide them for saving.

But why should they save? Interest rates for a term deposit are 3% per annum at best. And the cost of a variable rate home loan is as low as 5%.

Businesses can get financing for much less, depending on where they issue the debt. For instance, National Australia Bank Ltd [ASX:NAB] issued bonds in Hong Kong dollars this month, paying a coupon of 1.74%.

So why aren’t more consumers and businesses borrowing money in this ultra-low rate environment?

We partly explained that yesterday. When costs stay high, but income falls, that feels like inflation to the consumer.

In other words, despite the fact that prices have only risen a small amount, they could feel a whole lot more to a consumer whose wages have risen less…or whose wages have actually fallen.

Another reason is psychological. Thanks to government and central bank policies, consumers have become accustomed to rising prices.

It’s what they expect to happen in the future, because that’s what has happened in the past.

Because of this, consumers would rather be more conservative now, by saving, in the expectation that they’ll need to save more now in order to pay for a higher cost of living in the future.

This is the ‘paradox of low interest rates’. Low interest rates were supposed to stimulate the economy into action. They were supposed to encourage consumers and businesses to spend.

But all it did was encourage speculation on stock and bond markets. Those who bought assets did so because they assumed low interest rates would have a positive impact…and because they wanted to speculate on rising asset prices.

Those who sold assets did so because they weren’t as convinced about the longevity of the asset price boom. They got out while they could. It seems they were more conservative with their money, not necessarily ploughing it back into a booming market.

If those folks sold out a while ago, thinking asset prices were too high, it seems logical that they wouldn’t buy back in while asset prices are still high.

We do a whole bunch of reading every day. But we’re not sure that we’ve seen anyone offer this explanation for why low interest rates and money printing haven’t boosted the economy to the extent folks expected.

And we’re not sure we’ve seen anyone use this as an explanation for why inflation hasn’t taken hold as many (including me) thought it would.

Keynesians like to talk about the ‘paradox of thrift’. But that concept effectively pins the blame on the consumer. It suggests that, if consumers save rather than spend, it’s detrimental to the economy.

The ‘paradox of low interest rates’ is different. Governments and central banks cut interest rates in an attempt to avert the perceived problem of excessive spending.

In consequence, they created a new problem. Ultimately, it may lead to the same outcome. That is, the end of the multi-decade credit boom and a plunge into depression.

The moral of the story here is that if something is inevitable, it’s inevitable…regardless of what the brains trusts at the central banks think they can do to avoid it.

And on it goes…

In a post script of sorts, this story popped up on our screen from Bloomberg this afternoon:

‘[Brisbane-based fund manager] QIC expects the RBA to cut its benchmark rate in the second half of the year… Traders were pricing in an 80 percent probability that the central bank will reduce its cash rate to 1.75 percent from an already record low 2 percent within the next 12 months…

The ‘paradox of low interest rates’ continues.

Cheers,
Kris