How Low Interest Rates Are Drowning Capitalism

Reddit

Yesterday, the Australian market fell to its lowest point in six weeks. But it’s hanging in there so far today following falls in the US overnight. Gold and especially silver saw the worst of the selling. The bears are growling and look like pushing the metals below their June lows. It could get really ugly before it gets better.

That’s the thing with markets. They go to extremes. Jeremy Grantham, of value investing firm GMO, believes that ‘investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years.

Despite this, his gut feeling is that stock prices will continue to head higher. He still has the mad days of 1999 firmly in his thoughts. That’s when he refused to participate in the late 1990s bull market, which saw GMO haemorrhage money as funds under management collapsed.

Investors wanted in on the action, and GMO wasn’t a part of it. Capital moved with the market, giving it more and more upside momentum. The market moved to an extreme, until it couldn’t move any more. And it nearly sent GMO out of business.

Grantham thinks the market is in the process of doing the same thing again. Is he right? He might be. And he might not. Only hindsight can pinpoint market extremes.

It’s the same psychological game playing out in the gold market. Who needs the barbarous relic in their portfolio when stocks are clearly the place to be? China may be buying but so what? Their accumulation of physical can’t match the selling of western paper traders.

Momentum is to the downside and it will continue until it hits that unknowable extreme. Here’s a hint though…it’s getting close. The gold price is now below the total cost of production for many miners. They are losing money at these levels and bleeding cash. They’ll need to raise fresh capital. And if they can’t, they’ll go broke…kaput. 

Because interest rates are so low, miners can’t really hedge their production at prices that allow them to make a profit anymore. It’s not like it was in the late 1990s when the price of gold was last hovering around or below the marginal cost of production. Back then hedging was widespread. Higher interest rates allowed miners to take advantage of the time cost of money and forward sell their production at much higher prices than the spot price. But not anymore.   

If you’re a nervous owner of gold right now, think about this. Many of the world’s largest gold miners cannot produce (at a profit) the purified and refined gold you can buy for around US$1,220. You’re getting it cheaper than it can be profitably produced.

It’s a bargain. Yet people are selling it. They are selling it because the price is going down…which pushes the price down further and causes more people to panic and sell.

On another level you could interpret the falling gold price (and weak industrial metal prices in general) as a sign of coming deflation. If that’s the case, they’re well ahead of other markets. Global equity markets are in a robust inflationary phase.

So are house prices, as detailed by Dr Doom Nouriel Roubini in an article for Project Syndicate. Roubini gained fame for predicting the last global crisis. Now he’s predicting a replay:

‘It is widely agreed that a series of collapsing housing-market bubbles triggered the global financial crisis of 2008-2009, along with the severe recession that followed. While the United States is the best-known case, a combination of lax regulation and supervision of banks and low policy interest rates fueled similar bubbles in the United Kingdom, Spain, Ireland, Iceland, and Dubai.

‘Now, five years later, signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.

‘Signs that home prices are entering bubble territory in these economies include fast-rising home prices, high and rising price-to-income ratios, and high levels of mortgage debt as a share of household debt. In most advanced economies, bubbles are being inflated by very low short- and long-term interest rates. Given anemic GDP growth, high unemployment, and low inflation, the wall of liquidity generated by conventional and unconventional monetary easing is driving up asset prices, starting with home prices.

He concludes with:

‘What we are witnessing in many countries looks like a slow-motion replay of the last housing-market train wreck. And, like last time, the bigger the bubbles become, the nastier the collision with reality will be.’

What do you expect when all the world’s central banks are artificially controlling the most important price signal that capitalism has – interest rates? If you hold the price of credit down (repress it) the excess liquidity created is going to go somewhere. It’s going to inflate assets…stocks and housing.

It’s not going to go into the real economy…investing in plant and equipment or a new business venture is too much hard work when you can make quick and easy money speculating on asset price rises.

That’s probably why commodity prices are in a hole. There’s a lack of real world demand because there’s a lack of real world investment going on (apart from in China, which is why iron ore prices continue to defy expectations of price falls).

The abject failure of QE to do anything other than encourage speculation and further enrich those who played a major role in the last crisis is nothing short of a disgrace. That it will cause another crisis in the not too distant future should disgrace the central banking fraternity and expose them for the frauds that they are.

But it won’t. It will just encourage them to do more. Imbeciles will blame ‘capitalism’ instead of the academic central bankers who thumbed their nose at the market and thought they knew better. And the same imbeciles will encourage central bankers to use ‘new tools’ to ‘engineer’ growth.

Whatever…

The crux of the problem is that if you hold interest rates below the natural rate for too long, you’re drowning/suffocating/throttling the price signal that makes capitalism work. If interest rates (which are just the price of credit) are not allowed to transmit the correct price signals across an economy to regulate supply and demand, the ‘market’ will eventually force it to happen.

Where and when it happens, and in what form, is anyone’s guess. But it will happen. You can central bank on it.

Regards,

Greg Canavan+

Join The Daily Reckoning on Google+

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.
Reddit

Leave a Reply

6 Comments on "How Low Interest Rates Are Drowning Capitalism"

Notify of
avatar
Sort by:   newest | oldest | most voted
goldbuyer
Guest

Greg, do you predict that the larger gold companies will actually go kaput, or will they be able to ride out this (hopefully) temporary collapse?

shortchanged
Guest

Disgraceful, frauds, imbeciles, way to go Greg, you tell ’em. I agree 100%, as I have been saying so for a long time now.

Put some of the regulators in jail for not doing the job they are so handsomely paid to do, that might be a start

Will it change anything., I doubt it.

shortchanged
Guest

Addendum to above. But do it anyway

Joe
Guest
Since 2001 we have undervalued money. (Thanks Mr Greenspan). The Jewish bankers of the 15th century would never have loaned money without satisfactory usury. Funding shipping with a charge for potential uninsurable loss and also banker profit, was the principle of Banking, 0-0.5% was not. Zero to Half a percent – what is that!! And Mr Joe what interest rate would you like with that loan ?? Is it to be zero or is it to be a half a percent per year ? Well Mr Banker, i’d really like to be paying the half a percent because I think… Read more »
Freddy
Guest

“Many of the world’s largest gold miners cannot produce (at a profit) the purified and refined gold you can buy for around US$1,220. You’re getting it cheaper than it can be profitably produced.”

Gold was a fraction of its current price not that long ago and I doubt gold producers were operating at a loss back then. Have you considered the possibility of gold production costs falling and dragging gold prices down with it?

Nuno
Guest
Something that people don’t understand Interest rates are historicly low but they are not influencing anything The arguments in this article are not correct. NO ONE can get a loan at low rates anymore, this is a fraud ! Companies, home owners, the entire economy are getting correct interest rates of 5-6% as they should for this economic scenario The 0-.25% rates are servicing PAST debts from the buble era and are there to prevent a major bust in the world economy Those who have those interest rates are home owners with underwater mortgages, and companies/countries under finantial help. The… Read more »
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au