Not much happened in the US overnight. The market closed early for Thanksgiving. All the action was in Europe. Mario Draghi, Chief puppeteer at the European Central Bank, continues to wow his audience with promises of more stimulus.
As Bloomberg reports:
‘Yields on German five-year notes touched a record low, along with their Austrian and Italian peers, as investors added to bets that the European Central Bank will announce further stimulus measures when policy makers meet next week.
‘Price gains in bonds across the region have driven about a third of the yields on securities in the $US6.4 trillion Bloomberg Eurozone Sovereign Bond Index below zero. More than $US1 trillion of bonds now yield less than the ECB’s minus 0.2 per cent deposit rate, excluding them from the central bank’s asset-purchase program. Markets are pricing in at least a 10 basis-point cut to the rate, according to futures data compiled by Bloomberg.’
This is crazy policy. Yet it continues. In bond markets, the lower the yield, the higher the price. When yields go negative, it tells you that prices must be crazy high.
Draghi thinks he’s helping the real economy with such ‘stimulus’, but all he is doing is blowing a huge bond market bubble. When it busts, it’s going to be carnage.
According to Draghi, stepping into the market to buy an ever greater amount of government bonds will eventually create higher inflation. Apparently that will be a good thing.
But central bankers are powerless in their attempts to control the price of goods and services. They’re very good as controlling asset prices, mind you, but you won’t ever hear them admit that.
In 1906, the great Swedish economist Knut Wicksell wrote a book called The Influence of the Rate of Interest on Prices. In it, he said:
‘The rate of interest is never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies.’
In other words, if the rate of interest for a business to borrow is 3%, but the business owner sees demand growing by only 2%, why would they incur the cost of borrowing?
If you’re a government on the other hand, a 3% interest rate is great. It makes debt-servicing costs lower and allows you to borrow more. The problem, when it comes, will be someone else’s to deal with.
While very low interest rates might not be enough to encourage businesses to borrow and invest, they are certainly low enough to encourage hedge funds and the like to borrow and speculate.
The easiest game in town right now is buying European government bonds. But because bond price movements are usually pretty tame, hedge funds get more bang for their euro by using borrowed funds to ‘leverage’ these gains.
While Draghi’s stimulus is not doing much for the real economy, it’s having a big impact on asset prices.
But is trying to exterminate the interest rate — the most important price signal in the world — a smart thing to do?
Another great economic thinker, the Austrian economist Ludwig Von Mises, didn’t think it would work out too well.
‘…there cannot be any question of abolishing interest by any institutions, laws, or devices of bank manipulation. He who wants to “abolish” interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of the capitalists to receive interest. But such decrees would bring about capital consumption and would very soon throw mankind back into the original state of natural poverty.’
What’s old Ludwig on about? He’s saying that abolishing interest will completely screw with the system of capitalism. Interest rates are vital in their role of providing signals about consumption and production.
They are also crucial in valuing assets. That’s what Mises meant about getting people to value an apple 100 years into the future as the same as a present day apple. The present day apple should be much more expensive.
That’s because it’s more valuable. It’s in your hand, you can eat it. The future apple may never arrive!
Swap the apple example for a stock (or a market as a whole) and the message becomes frighteningly clear. If the value of a stockmarket is the same now as it is in 100 years’ time, that means you will get no return from it over the next 100 years.
The rate of interest signifies people’s hopes and fears. It is a measure of risk. If there’s no risk, there’s no return.
Put another way, with each stimulus attempt Draghi pushes asset prices closer to the point of no return. I mean that quite literally. The longer term holder of most European bonds right now will not get a return on their investment.
That’s why there are almost no longer term holders of European bonds. There are only speculators hoping to squeeze out a little more in central bank assisted returns. When the stimulus party eventually ends, they will bail en masse.
Glenn Stevens at the RBA would do well to heed this warning. Despite interest rates being at generational lows, business investment in Australia is collapsing. From the Financial Review:
‘In figures that challenge nascent signs of a recovery in business conditions, spending by companies on new equipment and structures collapsed 9.2 per cent in the third quarter, the fourth straight quarter of falls, the Australian Bureau of Statistics (ABS) said on Thursday. The drop was more than three times the amount forecast by economists.’
Having gone through the biggest investment boom in our history, we are now entering the bust phase. And it will get worse, as investment spending at several large scale projects drops off over the next few quarters.
Will Glenn do a Draghi and hope that lower rates magically conjure up higher levels of business investment? More than likely yes. And more than likely, lower rates will have no impact on business investment.
Instead, they will just increase speculation in the housing market and lead to ever greater household debt accumulation.
Then, when households come under pressure from too much debt, some idiot economist will call for the RBA to cut interest rates. And the RBA will, of course, oblige.
For The Daily Reckoning