In our August letter we pointed out that the turnaround in global economic growth would continue to reduce central bank enthusiasm for QE (bond purchases) and lead to sustained upward pressure on bond rates. To date, central banks are holding the line on short rates, keeping them near zero. It is only a matter of time before that ends. Rising short rates will add to the upward push on bond yields. Under “normal” circumstances, this pressure would be seen as a regular late cycle occurrence. However, the financial world is currently a long way from normal.
Super-easy monetary policy, involving central bank asset purchases of nearly US$9tn since 2007 and extraordinarily low interest rates have been used successfully since 2008 to prevent a banking collapse and depression. However, they have had two other very significant effects.
One of these has been to create pockets of speculation in interest-sensitive areas—some equity sectors, such as the NASDAQ and high-dividend paying stocks, real estate and, in particular, fixed income products. A number of key emerging market countries are also on the list. The carry trade, whereby investors borrow cheaply in an anticipated weak currency (the yen for example) and invest in fast-rising assets in another country with an expected rising currency has been massive. Now that the carry trade is unwinding, emerging markets are looking particularly vulnerable, including China, Brazil and particularly India, where the rupee has fallen nearly 25% since May.
The other major effect of the cheap monetary policy has been to encourage an increase in private debt in many countries (e.g. Canada, Brazil, China and Indonesia) while at the same time making it easy for sovereign debtors (excluding the PIIGS) to finance their fiscal profligacy. The seriously troubled sovereign debtors have been forced into draconian fiscal tightening which has had the primary effect of collapsing their economies and tax revenues, causing debt:GDP ratios to actually rise. Others have reduced deficits somewhat but total debt is still rising and the important ratio of gross debt to gross national savings is still deteriorating in most countries.
As interest rates rise and the speculation that was based on ultra-low rates unwinds, we could well find that, once again, the world still owes too much money.