Why You Should be Interested in Interest Rates


The savers of the world have been sacrificed for the global economy’s greater good.

A fractional banking system — where banks can lend 10 times or more their deposit base — means borrowers’ interests (pardon the pun) are always going to trump those of savers.

Central bankers couldn’t give a toss about those who’ve lived within their means and put a few bob away.

Lower interest rates are here for one reason and one reason only — to lower the cost of the ‘fuel’ that’s powered the economic engine for the past three decades.

In a world swimming with debt, low interest rates are the indebted’s life preserver…and a lead weight for savers.

Australian savers who complain about earning 3% on their cash should spare a thought for those in Europe, USA and Japan. Deposit holders in ‘the rest of the West’ are struggling to find a bank backed rate anywhere near 1%.

Savers are punished while those in debt are rewarded. What a screwed up set of priorities this highly debt dependent economic model has created.

If you doubt the veracity of this statement, imagine the wails of protest (from borrowers and retailers) if the Reserve Bank of Australia announced a 1% increase in interest rates? The political pressure applied to the government (from indebted constituents) to somehow right this wrong would be enormous.

On the flipside, when rates drop 1%, the savers take it on the chin and get on with life. They tend to suffer in silence. No one much cares about their plight.

In a world where those with debt are given a reprieve, the savers (not content with earning bugger all) are forced to expose their capital to all sorts of interest bearing ‘investments’.

High yield (the fancy name given to junk bonds) investments are the beneficiaries of frustrated savers.

John Hussman of Hussman Management made these comments recently (emphasis mine):

[I]n the first two quarters of 2014, European high-yield bond issuance outstripped US issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the "reach for yield" provoked by zero interest rate policy. […] Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher-yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.

Hussman is a former professor of economics and international finance at the University of Michigan, and according to Wikipedia, ‘He is known for his criticism of the US Treasury and the Federal Reserve and for predicting the 2008-2009 US Recession.

Can you believe over three quarters of the junk bond issuance came from the PIIGS? Two or three years ago, these countries were being vilified for their reckless economic management. Investors hungry for any sort of interest rate have very short memories.

In support of his comments, Hussman published the following chart showing the number of junk bond offerings and dollars raised are on the rise — since 2012 over US$1,000 billion has flowed into junk bonds. Not even the good ole pre-GFC days saw this level of funds flow.

European investors are following the lead of their counterparts across the Atlantic.

The following chart from the Federal Reserve Economic Data (FRED) shows the yield (interest rate) paid on BB rated investments has steadily declined since the GFC induced spike — which reflected the risk of default at that time

The definition of a BB rating (from Investopedia) is:

This is the next rating down from the highest non-investment grade rating, regarded as speculative. This rating is assigned to less creditworthy carriers and securities by the ratings agencies. Investors and policyholders of these entities face a higher risk of default.

Would you accept a 5% return for an investment that carries a higher risk of default?I wouldn’t. But overseas investors are…and with great gusto.

It’s this blind obsession with yield that’s prompted Indian central banker Raghuram Rajan to publically express his concerns about where this might all end up.

On 11 August 2014, Time ran this headline for an article on Rajan’s comments: A Global Financial Guru Who Predicted the Crisis of 2008 Says More Turmoil May Be Coming.

At the core of Rajan’s concern is the idea that the extended period of suppressed global interest rates is forcing people to make unhealthy investment choices.

No dispute from me. The data certainly shows people are making decisions with their wallets and not their brains. This is not in their or the economy’s best interests (pun intended).

When the market inevitably corrects this distortion of capital allocation, the losses will be enormous. The repercussions of savers losing billions and possibly trillions of dollars will be felt in all corners of the world.

Hussman and Rajan both possessed the foresight to see what was happening prior to the GFC. Their latest warnings should be heeded by any investor who places a greater weighting on the return OF capital rather than the return ON capital.

In Australia we have been a little more fortunate with interest rates. However, if the past few weeks are an indication, it appears the saver natives are getting a little restless.

I’ve fielded a number of queries from readers and friends about the merits of various higher yielding investments that have caught their attention.

The simple rule of thumb is once you step out of the confines of an Approved Deposit Institution (an ADI is a bank, credit union or building society covered by the government deposit guarantee) you are knowingly or unknowingly accepting a risk to some or all of your capital.

Never forget the wisdom of ‘what the big print giveth, the small print taketh away’.

The big print always offers a seductive rate of return. But if you look hard enough you usually find a little tiny asterisk somewhere.

One offering I was asked about had this acknowledgement in the fine print towards the back of the document:

This facility is not credit rated, and like many facilities, there is a risk of losing some or all of the principal and interest. You are to additionally note that this is not a bank deposit nor is this a term deposit.

This investment offered a rate of return double that of an ADI.

But does an extra 3 or 4% compensate me for the potential loss of 100% of my capital?

For me the reward/risk equation is definitely not in your favour with this offering.

However, most people do not assess the downsides of these offerings until it’s too late.

The warnings by Hussman and Rajan mean you need to take a real interest in interest rates. This is the powderkeg that’s likely to blow the whole debt dependent model to smithereens.

Vern Gowdie
For The Daily Reckoning Australia

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Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.

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4 Comments on "Why You Should be Interested in Interest Rates"

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2 years 2 months ago
“And here’s what Hussman wrote about the stock market a year ago [2012]: “Hussman: Bear Market Looms Despite Flirting With Record The stock market’s recent advance to almost record highs isn’t a sign of good things to come, says John Hussman, president of Hussman Investment Trust. “ “[T]he present is a terrible time to accept a significant amount of market risk,” he says in his weekly market commentary. “While it’s impossible to predict where the market is headed over the next week or month, “there is strong precedent for extended market losses and bear markets following overvalued, overbought, overbullish, rising-yield… Read more »
slewie the pi-rat
slewie the pi-rat
2 years 2 months ago

some peeps may consider Hussman to be still-reliable and Rajan’s job is to try to navigate India through criminal-infested waters from his exalted position and connections w/ the BIS, but they are show-men to a pi-rat.

wing-nuts have been predicting doom from higher interest for quite some time now, especially in their near-unanimous

slewie the pi-rat
slewie the pi-rat
2 years 2 months ago
opps! sry. just like my e-mail! L0L!!! …CERTAINTY that tapering MUST lead to higher interest rates, which, of course, MUST lead to certain doom for all investors who do not follow their advice. just the opposite has actually happened. the taper is in its latter-days, and interest rates are down. so far. so, tapering is NOT tightening, dammit, and slewienomics has agreed with the FED on that since Day 1. gleefully, too. now, we are certainly well into a new, improved, “MIT engineered” can-kicking regime under Dodd/Frank [since ~mid-2010]. predicting another debacle takes neither intelligence nor courage. after all, we… Read more »
2 years 2 months ago

Do not invest in anything that is dependent on crude oil. Pretty much everything.

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