February 12, 1999.
That was the date something never before seen, happened. The Central Bank of Japan, battling persistent recession, cut official interest rates to zero.
At the time other central bankers around the world criticised the move. Savers must be rewarded for savings. Borrowers must have to pay something to borrow. Without these basic financial assumptions, does the money world still make sense?
Many predicted inflation would result. You will recall back in Episode 111 I explored the enormous damage out of control inflation can cause.
Yet over 20 years on, Japan hasn’t descended into an economic basket-case.
So as central banks around the world all head towards lower and lower interest rates, what are the lessons we can learn from Japan’s experience to provide some insight into what zero interest rates might mean for normal people like you and me.
Where are the opportunities, and what pitfalls do we need to keep alert for?
We’re all aware that interest rates are low, and have been trending lower. Talk in recent months of inverse yield curves highlights the expectation that this low rate phenomenon is expected to last a long time. Inverse yield curves mean that it is cheaper to borrow money over the long term, usually 10 or 30 years, than it is to borrow for shorter terms – 30 days to 2 years.
Australia has had an inverse yield curve for quite some time, and the US joined the club in August. It’s certainly an interesting situation. Imagine you are a fund manager looking after millions of dollars in retirement savings for your clients. You have a chunk of money you want to invest in a stable, low risk option. The choices you are presented with are locking your client’s money up for 2 years in a government bond, and earn 2%, or lock it up for 10 years, and accept a lower 1.8%.
In any normal universe, you would expect to be paid more to lose access to your money for 8 years longer, yet in today’s inverse yield curve world, that’s not what’s happening.
So what can we draw from this seeming irrationality? It certainly points to a fairly pessimistic view of the future for interest rates. It tells us that investors feel that whilst interest rates are low now, they are heading lower, so that 1.8% over 10 years might well look like a wise investment a few years from now.
And they have some basis for this. Long term bonds in Europe offer negative interest rates. That is to say that when you buy say a German government bond, not only do you get no interest, you actually receive back at maturity a little less than you originally invested.
In that context, it’s not difficult to see why a bond investor might be keen to lock in at least a positive return for the long haul.
I’m keen to get to the opportunities and potential pitfalls of such an environment, but before we jump to those, let’s just spend a brief moment examining why central banks around the globe are implementing such extreme monetary policy.
As I mentioned at the beginning, Japan’s original leap into zero interest rates flowed from a desire to break a persistent recession during a period now referred to as “the lost decade”.
Yet today most economies around the world are ticking over relatively fine and unemployment is generally low. There has been no global “lost decade” globally.
So why are the world’s central bankers cutting rates so aggressively?
Cutting interest rates is supposed to incentivise businesses and households to borrow, spend, and invest. It should spur on economic activity, and create price rises – inflation. Inflation further encourages people to get on and buy, as the longer they delay, the more their new TV, or house and land package will cost.
That’s the theory anyhow. Interest rate cuts should be a quick jolt, like a defibrillator on a medical TV show where the doctor yells “clear” and then applies the paddles to the patient, hoping to get their heart started again.
Inflation should pick up, and then interest rates rise back up to normal levels to keep inflation from getting out of control.
Yet Japan’s experience is that once cut, it’s very hard to get rates back up again. Over 20 years on from their bold move, interest rates remain at zero, despite several unsuccessful attempts to get them back up again.
Beyond Japan, what other examples can we see to shed light on the impact of zero interest rates?
Sweden has had not just zero, but negative interest rates for some time. Negative interest rates should cause inflation as people buy now rather than delay with cheap borrowings. Yet the official inflation rate is only 1.9%. Property prices however have risen strongly. The graph below shows the clear relationship between falling interest rates and rising house prices.
Other European countries, most especially Germany, have experienced the same thing – wages are flat, the economy is only limping along, yet housing prices have risen strongly.
Shares too have tended to gain, though the ease with which investors can invest around the globe has made isolating the growth due to zero interest rate countries difficult.
Here in Australia, with shares throwing off dividends of over 4%, plus franking credits on top, it’s not difficult to imagine strong gains in prices, as demand for higher returns than the meagre interest rates payable on term deposits pushes cashed up investors towards the share market.
In Japan, the Central Bank, in it’s efforts to further stimulate the economy, has resorted to buying shares via ETF’s (Exchange Traded Funds). They are now estimated to own over 70% of all the ETFs on issue on the Japanese stock exchange, and around 3% of the total Japanese stock market. It must be tough to lose on the Japanese stock market if you know the central government has a persistent appetite to buy.
So then where are the opportunities?
Hard assets – shares and property – have been the main beneficiaries. Even Bonds increase in value in the early phase of the cycle. The winners then, are those with capital to invest.
Number 1 – wage earners. Pay rises are anaemic wherever rates are low though cause and effect are tough to unravel here. And flat wages but rising property prices is a challenging mix for the young especially.
Number 2 – cash investors – those who like term deposits for instance.
The learnings we can take from Japan and Europe is that zero interest rates don’t cause inflation in normal everyday purchases. Instead inflation emerges in investments assets – property, share, and perhaps bonds.
This shines a strong beam of light on your opportunities and also your potential pitfalls. In a world where money is free asset prices go up. Wages rises are rare, but most people have work. And people with cash savings or a preference to not own shares or property are hurt.
Be sure to get yourself on the right side of the ledger.