Why Are Interest Rates So Low?

Quite frankly, I don't really know and I can't make heads or tails of it. The current environment is a classic case of my habit of missing regime/paradigm shifts. The scales usually drop way after the trend or the event has manifested itself.

There are numerous reasons posited:

• Savings glut (this one is a mystery to me when you look at savings rates relative to history and trends...the argument is the savings glut comes from China/Russia/Brazil).
• Supply deficit (can't quite work this argument out; I think it relates to QE and lack of collateral).
• QE (combination of reduced supply and scramble for collateral).
• Financial repression (combination of debt overhang and distorted price signals from QE).
• Low inflation (yes inflation is low and has been trending down...let's call it declining inflation, but it is still positive and real rates are low). 
• Fears of deflation (I don't see deflation...commodities have taken it on the chin in the last year, but asset prices have gone through the roof and commodity prices are cyclical).
• Fears of market collapse/capital protection (maybe...but those Wally's have all missed the boat).
• Currency wars (fight to the bottom). 

I just can't understand why any investor would settle for a negative interest rate. This makes no sense to me at all. US rates look as attractive as ever relative to European rates. European rates are crazy. What are they telling us? Imminent collapse in the Euro? Maybe!

It should be noted, that you can't talk about why interest rates are so low in the US without taking account as to why they are so low (or even much lower) elsewhere.

Playing with fire

From January 1941 through September 1981, per Bernstein's figures, U.S. Treasuries shed 67.3% of their real value.

At a 3% nominal yield and 2.5% long term average inflation…locking in 0.50% real return….if inflation really gets going then all bets are off...and that return doesn't even take account of taxes.

Here is the real risk. Catastrophic risk. I don't think it is deflation. That is because the central banks are already all in on that one. They have already told us in no uncertain terms that they will do everything they can to forestall deflation. Fine. I believe them. If deflation takes place then the CBs are going to combat it. I think the real risk is that they are skating on thin ice. They not only lack credibility (they have used much of it up) but they lack the capacity to expand the monetary base (it is already overextended/on borrowed time). The likely result is things flipping from deflation to hyperinflation as total trust and confidence in the system evaporates. They are skating a fine line right now. If they do manage to get us out of the fire, then they will have been incredibly lucky.

If we don't go into deflation again, then we risk rising inflation and potentially hyperinflation (although that would require a real shock to the system).

We have plastered over the cracks. The system is fragile. Our psyches are fragile. Confidence is fragile (although I think it is very much seeping into the system at the moment and could very easily take us to the next level). But the whole thing is a facade, an emperor with no clothes. No one knows when the music will stop again, but stop it will.

An important article on deflation and hyperinflation

Here is a link to an article I found very useful in describing the relationship between deflation and hyperinflation.

The article is titled, How Deflation Creates Hyperinflation and is by Eric deCarbonnel.

What I found most interesting was the description of how hyperinflation takes hold, and how the accelerating velocity of money signals not animal spirits, but increasingly fearful spirits. We could do with a little increase in the velocity of money right now to unclog the system. But, be careful what you wish for. I doubt that we will undergo hyperinflation here (hyperinflation is generally only associated with failed states), but the possibility of heightened inflation (10%-15%) is not out of the question. Much depends upon the strength, the courage and the independence of the Fed, and its commitment to fight inflation. On the basis described in the article, I would say that Japan is a potential candidate for hyperinflation at some point in the future (although the demon of demographic deflation will serve as a counterweight...much will depend upon whether all those seniors retain their faith in the existing order).

Note: Somewhat strangely I think it could be argued that the American penchant for cynicism toward big government makes it a greater candidate culturally for hyperinflation compared to the more conforming Japanese culture. Only time will tell.

Inflation v Deflation? Yes!

Is it possible that we could get inflation in "hard" assets, and deflation in consumer prices?

I guess so.

It is hard to reconcile these two contrasting effects, but it may be possible. After all, all things are possible, but not all things are probable.

That having been said, a case could be made that monetary profligacy needs an outlet, and hard assets appear to be the place of choice. Conversely, it is also possible that a deleveraging economy based on a crippled consumer could lead to declining consumer prices.

We've already seen significant asset deflation (a 60% haircut is not much fun), but not much of an effect in consumer prices (stripping out energy and housing if you follow the core numbers...which I think is a joke but it suits the argument I am making here). With the market having bounced 39%, that looks like a correction to an overreaction, but we are still to see the follow-on deflationary effect on consumer prices take hold. I think its coming though. Rising unemployment, rising foreclosures (across the credit spectrum), less access to credit, rising savings all point to lower consumption.

Lower demand points to lower prices. After all it is still a competitive economy (just).

Deja Vu

Is it just me, or am I seeing the goins on today as similar to the goins on of 2002-03.

Back then deflation was the watchword...just as it is today.
Back then, they dropped rates to historically low levels...just as they have today.
Back then, every man and his dog rushed a secondary to market (lots of convertibles)...just as they are doing today.

Will the monetary and fiscal stimulus of today provide the same escape as it did back then?

There is one thought that we are caught on a counter-cyclical policy treadmill in which each time we dip into the well, we are digging a larger and larger hole for ourselves and compress the market cycle further.

Remember, the piper doesn't play for free.

A Quick Few Thoughts On Deflation

These are superficial musings.

(1) We've seen substantial asset deflation thusfar in this crisis, but very little consumer price deflation (we have seen a substantial deceleration in consumer price inflation, but not consumer price deflation).

(2) There is a chance we may enter into consumer price deflation. There is substantial productive overcapacity in the US and overseas, which could lead to a second wave of flow-on effects (more firings and competitive price declines...to cover fixed costs), all of which could feed upon itself in a self-reinforcing downward spiral, accentuated by global competition (pseudo protectionism).

(3) I think we have seen the first wave of this crisis, and we are now at a juncture where we are waiting and seeing if there are second order flow-on effects coming through the system. We could be in a period of the "lull before the storm."

(4) If a second wave arrives and we enter into a period of consumer price deflation, then the market is going to take a bath again.

(5) The market is currently rallying on the premise that we will avoid consumer price deflation and the consequent debt deflation of Irving Fisher fame.

Holding my breath! You should hold yours also.

Where There Is Smoke, There Is Fire

Excellent Weekend Interview in the WSJ, highlighting the rot (basically poor structure, corrupt practices, and perverse incentives...sound familiar) that exists within the US legal system ("He Fought the Tort Bar - and Won").

Given our recent experience of an unsustainable imbalance (financial crisis), it reminded me of the importance of identifying other areas in the system that are rotten. These will be ruled by Stein's law "if something can't go up forever, it will stop."

There is a price to be paid for corruption. And, there is a day of reckoning. Getting a handle on how and when it will play itself out is the hard part. But first you must identify where the problems lay.

Here are a few suggestions of unsustainable imbalances:

Political/democratic process and systems - perverted by money
Healthcare - perverted by vested interests
Tertiary Education - 10% pa inflation unsustainable
Defense spending - military/industrial complex + political ideology
Unfunded Entitlement Liabilities - self-evident
Fiscal Deficit, Current Account Deficit, Govt Indebtedness - not sustainable, but...

I think that each will have their "Minsky Moment" but the damage from their fallout, in most cases, will be less severe than an overly leveraged financial system (the multipliers there are huge).

I will talk much more about these things at another time, as well as possible ideas as to how each of their unravelings may play out.

P.S. While we are essentially on the subject of systemic risk factors, here are two other substantive risk factors with systemic possibilities - inflation and deflation. More on those at another time also.