Can The World Afford Higher Interest Rates?
That's the end of QE tapering talk then? Not quite, but it should die down somewhat, give U.S. Fed Reserve conduit Jon Hilsenrath's latest kiss-and-tell article in The Wall Street Journal. Thankfully, it might also stop all the blather about the U.S. and global economies recovering (they're not) and this being the end of the bond bull market (premature). What most investors fail to realise is that developed markets, including the U.S., simply can't afford a normalisation in interest rates: higher rates on government debt would crush their economies. This means QE tapering is highly unlikely and the current money printing experiment will only end when investors lose faith in government bonds. Where getting closer to that end game, but we're not there yet.
If the above is right, we may be in for a prolonged period of volatility where investors expect QE to be cut back, it may indeed get cut back at some point, only to increase again when it's recognised that any normalisation in interest rates will create huge problems. For emerging markets such as Asia, it'll mean increased volatility, although I'd argue the past week's stock market moves are reverting back to normal from an abnormally tranquil period over the past 3-4 years. This will create some opportunities, but be aware that the odds still favour a bond market crash at a later date.
What's behind the past week's action?
What explains the tumultuous market action of the past week? Put simply, there have been escalating fears that U.S. Federal Reserve will cut back on its US$85bn a month stimulus program. This has led to rising U.S. bond yields over the past month, thereby putting upward pressure on yields around the world.
Cutting back on QE would mean reducing the printed money that the Fed has been using to buy bonds. That would result in less liquidity, less money in the financial system. The printed money has helped support asset prices, particularly stock and bond markets. Less liquidity would reduce this support.
Much of the printed money had leaked into areas offering the best growth prospects, primarily emerging markets such as Asia. This led to some spectacular stock market performance, especially in South-East Asia. Naturally, talk of QE cutbacks hit the best performing, less liquid markets such as Thailand, the Philippines and Indonesia especially hard.
Japan is another matter. Stimulus equivalent to 3x the U.S. as a proportion of GDP and an inflation target of 2% has resulted in manic action across Japan's stock, bond and currency markets. The yen has snapped back after being oversold, but remains extremely vulnerable given the stimulus policies of the Bank of Japan (BoJ).
Meantime, Japan's bond market has investors fleeing due to a 2% inflation target almost guaranteeing them large losses and a central bank intent on keeping yields low to prevent interest being paid on government debt spiralling out of control. Investors are starting to realise that the government may not win this battle.
There is an alternative view: that the reason for the recent Japanese volatility is that the BoJ is backing away from its inflation target and stimulus efforts. It's a laughable notion put forward by seemingly respectable commentators (see here). It ignores the fact that if the BoJ's efforts succeed, rising inflation will eventually lead to rising bond yields and interest rates, which will kill the Japanese economy (see here for my previous article on this).
Later in the week, of course, the Fed came to the market's rescue. Via its Wall Street Journal mouthpiece Jon Hilsenrath, the Fed essentially tip-toed back from earlier suggestions that it would soon reduce QE. Here's what Hilsenrath had to say:
"The chatter about pulling back the bond program has pushed up a wide range of interest rates and appears to have investors second-guessing the Fed's broader commitment to keeping rates low.
This is exactly what the Fed doesn't want. Officials see bond buying as added fuel they are providing to a limp economy. Once the economy is strong enough to live without the added fuel, they still expect to keep rates low to ensure the economy keeps moving forward."
Below is the U.S. 10 year government bond yield, courtesy of Yahoo.
The maths against higher rates
Amid all the hoopla about whether the Fed will cut stimulus or not, investors (and the mainstream media which covers them) seem to be ignoring a more fundamental issue: can the developed world cope with a normalisation in bond yields and thus interest rates?
To answer this question, let's crunch some numbers. Bond guru Jeff Gundlach has looked at the impact of higher rates on the U.S. and he doesn't like what he sees. He suggests that if interest rates in the U.S. normalise and increase 100 basis points annually over the next five years, the interest expense on government debt would rise from US$360 billion last year to US$1.51 trillion.
To put this into perspective, the recent U.S. government cutbacks which many worried would tip the economy into recession totalled just US$85 billion. Any normalisation in rates would result in brutal cutbacks to government programs, seriously impacting the economy.
For another example, we can look at Japan. As I've stated on many occasions, if rates rise to just 2.8%, interest on Japanese government debt would be the equivalent of 100% of government revenues.
The implications of higher bond yields and higher interest rates would go well beyond government debt though. Other countries with fewer government debt issues would suffer too. For instance, my native Australia is relying on the property sector (a bubble slowly deflating) to pick up some of the slack from a mining sector which is getting hammered by a slowing China. Any rise in Aussie rates would quash any hopes of a housing recovery (even if it was highly unlikely to happen anyway).
In Asia, a normalisation in rates would have a broader impact. Higher rates and tighter money would hit elevated asset markets across the board, including the stock, bond and property markets. Those which have benefited most from the low rates and subsequent money inflows, such as South East Asia, would be hurt most. In effect, the past week would be a taste of things to come.
A bond crash will have to wait
If I'm correct, central banks can't afford to turn off the stimulus tap. If there are any signs of rising bond yields, these banks will print more money to buy bonds and keep the yields down. In other words, you shouldn't expect less stimulus going forward, but more.
Central banks can keep this game going for a long time, but there will come a point when the bond markets will say enough is enough. As I wrote in an article on Japan recently:
"In many respects, Japan is the template for what's to come in other developed markets. After an enormous credit bubble which burst in 1990, Japan has refused to restructure its economy in order for it to grow in a sustainable manner. Instead, it's chosen the less painful route of printing money to try to revive the economy and reduce debts in yen terms...
... The trouble with this is that there comes a point where bond investors lose confidence in the ability of the government to repay the money. These investors then refuse to rollover government debt at low rates. When bond markets dry up, they normally do so quickly. The current wobbles in the Japanese bond market can be seen as a prelude to this endgame.
Though Japan has escaped its day of reckoning for a long time, other developed markets are unlikely to be as lucky, given the extent of their indebtedness and continued commitment to flawed policies."
What it means for Asia
Investor reaction to recent market volatility in Asia has been fascinating to watch. It's almost as if investors have forgotten that emerging markets, and particularly Asia, experience sharp spikes and dips on a regular basis. It's a classic case of an investor bias known as recency bias, which is essentially extrapolating from recent events into the future.
The reason that I say this is that when I worked in South-East Asia for three years (2006-2009), the volatility experienced during recent weeks was the norm rather than the exception. And colleagues back then who'd been through the Asian crisis thought that I'd experienced little of the volatility that South-East Asia had to offer!
The recent volatility though is likely to become the norm again. Any hint of less QE will see hot money leave Asia, only to come back when it becomes clear that stimulus should be here to stay.
Last week, I suggested the rout in emerging markets would soon result in some opportunities in Asia. I didn't expect the rout to become an avalanche so soon, however.
There was some pushback to one of my top picks being the Indian market (Indian friends and subscribers seem to be the most pessimistic about their country's prospects!), particularly as the rupee hit all-time lows versus the U.S. dollar. If my thesis on QE tapering being a head fake is correct, then the rupee should stage a short-term rebound.
As for the many problems that India faces, such as the current account deficit, I do acknowledge that the country still has significant issues. The question is whether these problems are well-known and factored into the stock market. I'd suggest that they largely are and the incremental positives mentioned last week are not.
As for the other potential opportunity which I identified, Thailand, it's been getting pummelled as per other South-East Asian countries. Keep in mind though that the country is in the best shape that it's been in a long time. Thailand has a stable government, strong investment cycle, positive policies such as redistributing incomes from the capital to rural areas as well as battle-hardened companies who've seen politicians and crises come and go. Combined with reasonable valuations, particularly among bank and energy stocks, Thailand stands out as a sound, long-term investment story.
This post was originally published at Asia Confidential: http://asiaconf.com/2013/06/14/can-world-afford-higher-rates/
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