Lower Interest Rates are Provoking Fear and Saving

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Here we go again…

This week you’ve seen Japan announce yet another stimulus package, while Australia’s RBA cut interest again in a futile attempt to weaken the currency.

Overnight, the Bank of England (BOE) joined the circus — again — by announcing its first interest rate cut in seven years (by 25 basis points to 0.25%) and a £60 billion annual expansion of the current bond buying program. The Financial Times reports:

The Bank of England launched its biggest stimulus package since the financial crisis on Thursday and said it stood ready to make further interest rate cuts this year in an attempt to cushion a looming Brexit-induced downturn.

Mark Carney, BoE governor, said there was a “clear case for stimulus, and stimulus now” after a string of business surveys suggested the UK was heading for recession because of the uncertainty following Britain’s vote to leave the EU.

Well, I’m sure the BOE’s promise to buy £60 billion in UK government bonds (gilts) will assuage some of the uncertainty that businesses are feeling. They could well go out and make that investment they’ve been holding back on now, thanks to the BOE’s bold and courageous move.

On the other hand, it might not make a lick of difference to those operating in the real world. If you don’t know what the future looks like, a slightly lower interest rate, and another round of debt monetisation, isn’t going to make much difference.

But speculators love it!

The market immediately rushed into UK gilts as they tried to front run even more BOE purchases. Yields on 10-year gilts dropped 16 basis points, to 0.64%.

Keep in mind, the current BOE quantitative easing (QE) program is already at £375 billion per annum. With an additional £60 billion added to that, the BOE will monetise £435 billion in UK government debt per year from hereon in. But they’re not printing money, are they…

No wonder the pound dropped. It fell more than two US cents on the day.

In a sign of where the future of QE is headed, the BOE also announced a £10 billion corporate bond buying program. This is presumably to help corporates finance that investment they won’t be making because they have no idea what the long term impact of Brexit actually is…or whether Brexit is really going ahead.

So once again, the money will find its way into speculators’ pockets via higher assets prices.

By the way, these days, we tend to use the term ‘speculator’ in a derogatory manner. I don’t want you to think that is the case here. The speculators are merely doing what the authorities are practically begging them to do.

The famous trader and financier Bernard Baruch wrote about this in his autobiography. He noted the word comes from the Latin ‘speculari’, which means to spy out and observe.

Baruch defined a speculator ‘as a man who observes the future and acts before it occurs.

Baruch first came to Wall Street in 1898; to him, every speculator, or anyone involved on Wall Street, was ‘a man’.

Anyway, my point is that central banks and governments are the source of the problems. The speculators are just trying to take advantage of it.

And we are all speculators. We’re all trying to observe a very foggy future.

And the landscape is changing…again. It used to be that any announcement of stimulus would result in a Pavlovian response of higher asset prices. And while UK stocks and bonds reacted positively to the BOE announcement, US markets yawned.

Both the Dow Jones and the S&P 500 index finished flat for the session. Markets are more interested in tomorrow’s US non-farm payrolls report than what’s happening on the other side of the pond.

A strong employment number tomorrow will put the US rate rise charade back on the table. At least until some other data comes out to take it back off again.

Are markets over QE and lower interest rates? Is it time for central banks to play a new hand? Probably not just yet. The monetary policy dead horse has a bit of flogging left in it yet.

But don’t forget, markets are always ahead of the bureaucrats. Investors, or speculators, or whatever you want to call them, know that stimulus ultimately doesn’t work. Unless the announcement is unexpected, even asset prices are no longer responding.

This is especially the case in Australia. Yesterday, I wrote how it was a concern that the market sold off sharply following the RBA’s rate cut on Tuesday. Maybe it was a classic case of ‘buy the rumour, sell the fact’. That often happens.

But Aussie broker Marcus Padley has similar thoughts. He had an interesting take, both on Tuesday’s rate cut, and the market response. Via Livewire:

Interest rates are at a record low and although the markets had factored in a 68% chance of a rate cut, they didn’t take it well; the ASX 200 fell 50 points from its high on the day of the announcement. That’s a very short-term reaction, but an interesting one. We’ve reached an inflection point where lower rates don’t stimulate elation and spending as the RBA intend. They do the opposite, provoke fear and saving. Clearly, some things are changing. With interest rates, at 1.5% we’ve entered the world of small numbers.

Anyone who’s ever paid a 17% mortgage rate will tell you that interest rates are now almost irrelevant. The RBA could move from 1.75% to 0%, or minus 1.5%, and no one is going to change their current spending intentions because of it. Our central bank’s central monetary policy tool has already become pointless. Interest rates simply don’t matter anymore.

Try telling the housing market that interest rates don’t matter! It’s about the only asset class cheering the move.

But Padley’s point is a good one. Our household sector is already the most indebted in the world (relative to GDP). There is a limit to how much more household debt can contribute positively to the Aussie economy.

And that’s saying nothing of the social costs of pricing a generation of kids out of decent housing options, or the risks to financial stability and the banking sector by continuing to run the economy on the rickety leg of debt fuelled house price growth — and the resulting ‘wealth effect’.

There is a reason that interest rates are at record lows. That’s because the economy is cactus. Or cacti more like it. And the response from our politicians?

They get into a populist slanging match over the banks’ bad behaviour. What do they expect the banks to do? It’s like filling up a trough and expecting pigs to stay away from it.

If you soak an economy with easy money, banks are going to get their hands on as much of it as they can.

Australia, and the world, needs a whole new approach to thinking about how economies work. But, alas, that will only happen when we’ve finished with the current flawed experiment.

Regards,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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