Our GFC is Yet to Come

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Today’s Daily Reckoning starts with a spring in its step and a shadow box around the room. This New South Welshman is pretty chuffed after the Blues kept the State of Origin series alive with a win in front of a record crowd in Melbourne last night.

It was a glorious occasion. But alas, our beat here is money, not footy, so let’s see what’s happening in the world of high (and low) finance.

Overnight, the world’s chief moneymaker, Fed Reserve Chair Janet Yellen gave markets a boost by saying that interest rates will rise only very gradually. Apparently, this was news to the market. US stocks were in the red before Yellen spoke, but her soothing words pushed stocks into the green.

From the Financial Times:

The Fed chair said there were signs that the US economy had regained some momentum following a dismal start to 2015, as officials stuck with projections suggesting the first rate increase could come as soon as September.

However, Ms Yellen said policy makers still wanted to see more “decisive” evidence of the strength of the recovery before taking the first step. Projections released by the Fed suggested officials expect an even shallower subsequent path of tightening in the next two years, underlining how nervous rate-setters are about derailing a tentative recovery.

It’s not like the days-of-old folks, where an economic recovery would see a pretty swift move back to interest rate normalisation. These days, with the global economy weighed down by too much debt, a single interest rate rise is a serious matter.

That’s why, with interest rates expected to rise in the US in September, markets are tentative. The big indices in the US have gone sideways since the start of the year. They won’t like it at all if rates rise too quickly.

When debt levels rise, the potential rate of growth falls. It comes down to this thing known as the ‘natural rate of interest’. It represents the average return an economy generates from additional capital investment.

A high natural rate of interest encourages investment and promotes economic activity. To avoid this pick-up in activity morphing into a destabilising boom, the job of the central banker is to lift official rates to at, or slightly above, the natural rate.

The problem is no one really knows where this natural rate is. It’s invisible, derived from an aggregate of economic activity and millions of different investment decisions. The only rule is that when official rates are higher than the natural rate, activity slows, and when official rates fall below the natural rate, a boom ensues.

Over the past few decades, central bankers have obviously got it wrong. They have fostered destabilising booms around the world by holding interest rates too low for too long.

Such a policy stance promotes largely debt funded investment growth (think of the global real estate boom that reached a crescendo in 2007). When an increasing amount of investment dollars targets strong returns, each additional dollar achieves a lower and lower return. This is how the natural rate in an economy declines.

A low natural rate of return discourages further investment until such time as it starts rising again…and the cycle repeats.

But when central bankers hold official rates below the natural rate for a very long time, big distortions appear. Because low rates are a global phenomenon, this is a global problem.

So what is the problem exactly? Well, when official interest rates remain below the natural rate for a prolonged period of time, it encourages excess investment, which pushes the natural rate lower and lower.

At some point, even a low nominal rate of interest fails to stimulate economic growth. That’s because the natural rate is also very low, meaning there is little incentive to invest.

That’s the trap that global central banks are now in. Raising rates even a little bit will push the official rate above the low natural rate, which is contractionary. Leaving them low won’t help either, because the natural rate is in the gutter too.

I know this is all this is a bit technical, but it’s an important point. When you actively promote booms but aggressively avoid the busts, there is no natural cleansing of the bad investment decisions made during the boom. Bad debt lingers and soaks up an economy’s resources.

In effect, central bankers have their foot on the throat of the natural rate, not allowing it to get off the floor. And we’re all the poorer for it.

In Australia it seems like every politician and policymaker has their foot on the throat of the economy. The central bank has interest rates at record lows, the financial regulator, APRA, is doing nothing of substance to control the speculative housing boom, and politicians are standing back doing nothing, just hoping to get to the next election.

Meanwhile, Australia’s most important export, iron ore, is on the slide again. Steel prices in China are at record lows. This tells you the structural adjustment underway there (the move away from property construction) is well entrenched.

Iron ore prices fell for a fourth straight day yesterday, with the spot price trading at US$61.50/tonne. More ominously, the 12-month swap price is just under US$49. This suggests the spot price will head back down soon too. As soon as it falls below US$50, which it will, the government’s budgeted revenues will take a hit.

This will happen just as the household sector comes under more pressure. There will be calls on the government to increase spending to prop up economic growth. Just as we head into an election (probably sometime next year) the government will damn the consequences and spend up big.

It will be the last chance they get. The market won’t like it. We’ll lose our AAA credit rating and interest costs will increase, despite the best efforts of the RBA to keep the boom going.

Our GFC is yet to come. The question is, does this crash the market or make it boom? I’ll have a crack at answering that tomorrow.

Regards,

Greg Canavan+,
For The Daily Reckoning, Australia

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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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Constantine
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Greg, thanks for sharing your insights. What are your thoughts on housing market prices for the next 3-5 years? Will they significantly move lower, particularly in WA due to its heavy reliance on commodity exports? Or perhaps lower AUD could help offset some of the pressures due to capital inflows from overseas?

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