Ever since 2008 the global economy has been experiencing an unprecedented period of low interest rates, but in 2016, the US Federal Reserve began to tentatively increase rates with a view to staving off inflation caused by a decade of cheap and plentiful money supply. In addition, in late 2018, the Fed decided to start reducing the size of its massively overinflated balance sheet but panicked the markets and had to reverse course.
Yesterday’s announcement of a 0.25% rate cut means that they’re now reversing course on interest rates as well, indicating that rather than reducing their enormous market support, they’re actually having to increase it further.
What does this mean?
I’ve previously written (at length) about the challenges faced by the global debt mountain and the huge volumes of cash that have been pumped into the markets. The global economy faces a far greater debt burden today than it did in 2008 and the only way to reverse that is to turn off the printing presses and increase rates. The trouble is that the real economy isn’t actually strong enough to weather both of these measures at the same time (as evidenced by global market collapses around Christmas).
This is evidenced in part in the global debt markets. Some organisations such as pension funds and endowment trusts are legally required to purchase a certain percentage of bonds for their portfolios because they’re considered ‘safer’ than equities. These organisations compete on the open market for the highest rated debt which is usually issued by governments and the largest blue chip corporations and considered the least likely to default.
These organisations have to pay little interest to issue their debt and the quantitative easing (money printing) programme run by central banks has forced these rates down even further. Hundreds of millions of pounds, dollars, euros and yen has been printed and used to buy debt, artificially increasing demand and forcing down yields.
Under normal market conditions, if a company with weak cash flow, a poor record of repayment and significant liabilities tries to borrow more money, it will struggle to find a lender willing to buy its bonds or extend lines of credit. As a result, it might offer to pay more for the right to borrow (issuing high yield or ‘junk’ debt), but this money printing has had the effect of reducing the amount that they have to pay too.
As a result, global bond yields have totally collapsed, resulting in organisations that wouldn’t usually be able to borrow being able to issue debt, and consumers, governments and blue chips being able to borrow more money and at lower rates. As a result, global debt has ballooned.
The issue, obviously, is that when the central banks attempt to reverse this with interest rate increases, the cost of servicing all that debt increases dramatically, defaults rise, and the global economy seizes up as banks and credit card companies collapse and consumers and corporates have to pay increasing sums of cash into servicing their liabilities.
This has left central banks with a bit of a problem. If they do nothing, keep the printing presses running and keep rates artificially low, debt will continue to balloon, increasing global fragility, increasing the risk of inflation, and decreasing the amount of GDP available for productive investments in healthcare, education and infrastructure. But if they start to reverse it, the markets panic and the economy goes into a tailspin.
Personally, I believe the best course of action would be to keep interest rates low but to sell off the balance sheet gradually over time. It will be painful, of course, but less so than trying to pull both levers at the same time. The global economy is addicted to debt after ten years of easy money but increasing financial resilience is a measure we’re going to have to take sooner or later. The longer we put it off, the more painful it will be.