How can the UK adjust to a world of lower interest-rates and yields?

One of the features of the credit crunch era has been the fall and if you like plunge in both interest-rates and bond yields. This first started as central banks cut official interest-rates sharply as the crisis hit. When that did not seem to be working ( the modern word covering that is counterfactual) they then moved to policies such as Quantitative Easing to reduce longer-term interest-rates and yields. Next came more interest-rate cuts and the advent of Qualitative Easing which for a while was called credit easing in the UK. This now comes under the banner of the Term Funding Scheme in the UK, or actual support for loans at the Bank of Japan or the TLTROs and securities purchases by the ECB ( European Central Bank).

So we saw official rates fall and then central banks realised the consequence of controlling rates which run from overnight to one month money. This is that there are plenty of other interest-rates such as bond yields and mortgage rates so our control freaks moved to lower them as well. After all their Ivory Tower economic models predicted economic triumph if they did. To ram all this home some places also went into negative territory for interest-rates from which no-one has yet returned with Denmark briefly giving it a go before preferring another ice bath. For the UK we were reassured that we were at the bottom of the cycle as Bank of England Carney told us that a Bank Rate of 0.5% was the lower bound. Of course he later cut to 0.25% and then told us that the lower bound was near to but just above 0%. This of course was silly on two fronts. Most obviously it ignored the fact that much of Europe and of course Japan already have negative interest-rates and it also led to the really silly expectation of a cut to 0.1%.

The rise of the zombies

It was only a few days ago that I pointed out that in my opinion the rise of zombie companies and businesses was strangling productivity growth. That reminded me of my description of Unicredit in Italy as a zombie bank around 5 years ago and of course it still is. But in the meantime thank you to @LadyFOHF for pointing out this from FT Alphaville.

It quotes the Bank for International Settlements or BIS on this subject.

One potential factor behind this decline is a persistent misallocation of capital and labour, as reflected by the growing share of unprofitable firms. Indeed, the share of zombie firms – whose interest expenses exceed earnings before interest and taxes – has increased significantly despite unusually low levels of interest rates (right-hand panel).

That bit could not have been written by me clearly as if it had “despite” would have been replaced by “because of”. This bit might have though.

Weaker investment in recent years has coincided with a slowdown in productivity growth. Since 2007, productivity growth has slowed in both advanced economies and EMEs

There are dangers in assuming that correlation does prove causation but look at the right zombie company chart. Just as growth was fading the central banks gave it another push and rather than the reforms we keep being promised we in fact got “more, more, more”. More worryingly the line continues to head upwards.

In case you are wondering here is their definition of a zombie company.

The BIS dubs a zombie company any firm which is more than 10 years old, listed and has a ratio of EBIT to interest expenses below one.

If you are wondering ( like me) that others could be on the list then so was Izzy at the FT.

This means Uber, which is now eight years old, only has two years and a public listing ahead of it, before it too can be classified a zombie.

That I find fascinating as Uber and similar companies are a modern era triumph supposedly.In my part of London I regularly pass people holding up their mobile phone as they track down their Uber taxi. To be fair it has usually arrived in the time it takes me to walk past and in fact if it takes longer than that some seem to get upset. So here we really have a quandary which is a zombie which is apparently extremely efficient!

The FT poses an issue here.

why does profitability not matter anymore? And where does the extended patience with unprofitable companies lead us in the long run? Surely, nowhere good?

I will go further as on this road we see strong hints as to why productivity growth has been so low ( in fact more or less zero in the UK) which will hold back wage and real wage growth. All of them together mean that economic growth will be restricted as we are reminded of 2% being the new normal on any sustained basis. If we throw in the official under measurement of inflation we then find we have little if any economic growth at all. Is that enough as a consequence of low interest-rates where the “cure” has in fact become part of the disease? Perhaps Tina Arena was right.

I pretend I can always leave
Free to go whenever I please
But then the sound of my desperate calls
Echo off these dungeon walls
I’ve crossed the line from mad to sane
A thousand times and back again
I love you baby, I’m in chains
I’m in chains
I’m in chains
I’m in chains

The banks

The official story is that low interest-rates are bad for the banks. But if this from @grodeau about Swedish banks is true in the UK which I believe to be so we may have been sold a pup.

In terms of margin they are doing better than before the credit crunch as we find we are feeding a whole field of zombies like this is some form of new Hammer House of Horror series. Or to answer the question posed by Obruni in the FT. Yes.

The ROEs of most major banks have been below their costs of capital since 2008. Are these zombies too?

The UK should not issue more index-linked Gilts

There are suggestions that we should do this and as ever I will avoid the politics and just look at the economics and finance. I spotted this yesterday from Jonathan Portes.

Failing to borrow long-term at negative real rates to fix roofs (& other things) over last 7 years an act of deliberate economic self-harm

This reminds me of the online debate he and I had a few years back. The issue he  is apparently glossing over can be summed up in the use of the word “real”. In a theoretical Ivory Tower world it is clear but beneath the clouds where the rest of us live it has changed a lot in modern times. Let me summarise some issues.

  1. Imagine inflation were to stay at around 4% ( these are based on RPI inflation) for a while. Our negative real rate would in fact be very expensive as we paid it.
  2. We do not know what we will pay as our commitment is in fact open-ended depending on inflation. As it is so I am dubious about negative real rate calculations.
  3. If we switch to wages growth we see that something has changed. If that persists then the real rate versus wages may turn out to be very different.

If I was borrowing I would borrow in terms of conventional Gilts where the 30 year cost at 1.9% is extraordinarily cheap and a known cost as in we know what we will be paying from the beginning. Putting it another way index-linked Gilts are tactically cheap but I fear they will be strategically expensive.

Comment

As we look at the new economic world we see that some are trying to escape but that progress for them has been slow. After all the US has merely nudged its rates to a bit above 1% and Canada has only moved to 0.75% this week. So it seems that we will have to get used to low interest-rates for a while yet as we note that they have come with lower productivity, wage growth and economic growth. Not quite what we were promised is it?

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20 thoughts on “How can the UK adjust to a world of lower interest-rates and yields?

  1. A recurring theme on this blog has been to ask what the exit strategy is from QE. Your observation about index linked gilts, reminded me of a thought that occurred to me the other day. Namely that this could turn on Government borrowing and interest payment costs. THus, today the goverment could not afford an interest rate rise.

    However, as I understand it, the BOE is going to hold all the bonds it is buying to term, and pay the interest it received from the Government back to the Government. If, at the same time the Government is issuing fixed interest rate bonds, then a point could be reached when a rise in interest rates would not lead to a significant increase in the government’s cost of repayments.

    Interest rates could be increased, but holders of these bonds would then be looking at a relatively poor return – and the value of the bonds would collapse. They would demand a greater yield on any new issues.

    However, if austerity had, by that stage, wiped out the deficit – such that government revenues were in balance, the Government would not need to issue any new bonds and would not be beholden to the market.

    This sort of makes sense – and would suggest that the plan was to play out these low interest rates to 2020 or whenever the Government gets into surplus. But what do I know? Any thoughts?

    • Chris,

      If the UK Government ever gets to a balanced budget, it would still need to issue new bonds to refinance old bonds that came up for redemption – the stodk of old bonds would only gradually diminsh. But as it looks like we will never get to that point I guess this is just a theoretical question.

      • As Chris S-W said old bonds maturing or coming up for redemption would be cancelled so there is no need for refinance.

        Your point about never achieving a balanced budget is well made though.

    • Yes ChrisS, I made this very point a few days ago on here, there is absolutely no incentive for the government to borrow responsibly or to spend within their means either as no matter what happens to interest rates – in the unlikely event they ever do go up – the interest they have to pay comes back to the Treasury like a proverbial boomerang.If there is no interest charged and you never have to pay it back, you can borrow an infinite amount of money.

      Basically I think we have history repeating itself here, we are turning Japanese – I really think so, they bailed out their banks in 1990 but allowed the stockmarket to collapse over the following decades(the Nikkei fell from 38,000 in 1990 to around 7,600 in 2009 and is currently 20,000), we have bailed the banks out and I believe central banks(especially the Fed) are buying stockmarkets to prevent falls, property?well I think we all know the answer to that one in the UK, so if it has taken Japan nearly thirty years to achieve nothing, we are merely one third of the way along our journey.Only twenty more years to go!!!

      Central banks are confident they can keep this game going for as long as they want, noone can stop them can they?

      • The only counterbalance to govts ramping borrowing and indebtedness is a currency drop.
        That hasn’t happened and is I suspect the only thing that will cause a rate rise.
        With cable currently around 130,we’re starting to see some inflation in the pipeline but it’s just not converting into wage pressures-although I’m happy to be corrected.

        • Currency drop is the mechanism for UK correction. The Brexit debacle and the fact that Sterling is NOT euro and NOT doĺlar really puts in line for a kicking. Of course IR rises forced by currency weakness is Govts and BoEs worst nightmare but tell theyve a plan to avoid it….other than burning the population which theyve tried already..

  2. It is hard to know what to think about all this. Given the multiple changes to the inflation measures, I imagine that any government faced with high borrowing costs on index-linked gilts will find a way to fiddle the index down to, say, 0. At this point, the bonds will then be relatively cheap for the BoE to buy as part of its latest wheeze aka QE.
    It has been a long week. Perhaps I am getting too cynical.

    • Well,let’s be frank,they’ve been fiddling the inflation stats for years and readers of this site will be all too aware of how-the exclusion of housing,the inclusion of rental equivalence,substitution etc etc
      I for one fail to see why they’re issuing any when nominal rates but following in your cynical vein James,it might be apt to find where the BoE’s pension is invested and I’d be shocked not to find any linkers in there.

  3. Great blog as always, Shaun. You mentioned the 0.25 percentage points hike in the overnight rate by the Bank of Canada near the end of it. A lot of journos in Canada are highlighting it as the end of an era of low interest rates, because it is the first increase in seven years, although the overnight rate is still lower by 0.25 percentage points than it was as recently as December 2014. The turnaround in the BoC rhetoric has been spectacular since the interest rate was left unchanged on May 24, and the incoming economic data since then has sent mixed messages. This suggests that pressure from the US government lies behind this road-to-Damascus conversion by Poloz to a rate hike. If so, it may well be the first of several, since the Americans probably won’t be satisfied with the current rate.
    Poloz is likely to go down in history as the first post-inflation-targeting Governor of the Bank of Canada as his efforts to make this hike jibe with a 2% target inflation rate are simply farcical. Dave Parkinson picks up on this in the Globe and Mail:
    https://www.theglobeandmail.com/report-on-business/economy/economic-insight/rate-hike-shows-bank-of-canada-balking-at-inflation-at-least-for-now/article35672643/
    The comments from Slavophile on his opinion piece come from me.

    • The 2% inflation target has been source of endless comedy for years Andrew.

      It is quite stark how quickly the mood has changed which does allude to some behind the doors conversations having occurred.

  4. Shaun, A wonderful and insightful posting today. I love your dissection of the cause and effect muddle. They say despite, you say because. This conundrum goes to the heart of the fakery we suffer. The longer they stick to their interpretation the more obvious it is wrong….they argue…. the establishment …that low rates help struggling businesses survive, pay down debt and eventually prosper. We say SMEs were so abused by banks in 2008 that only the survivors learnt to live without borrowing. We say that the financial institutions are still carrying so many NPLs that low rates only support a continuum of never reconciling the underlying debt. We say that low rates accessible to internet innovators via financial intermedaries only support unprofitable “returns tommorrow pitches crap business models” . We say local govt, monopsonies and big business convert expensive debt to cheap debt reducing the need to respond to market pressures and properly serve customers or shareholders.

    They say feed the Zoo. We say starve the Zombies.

    Paul C.

    • Hi Paul C

      Thank you. Part of your reply reminds me of my father. He hated the banks because he had a small business in the building industry and in the good times they pretty much forced money on him. Then guess what in harder times? Yep they begged for it back at exactly the point he was least able to repay it. He only survived the 1980-82 recession because of an overdraft they gave him for buying some company cars which they had forgotten. Then a few years later they were pressing him so they could hit their targets except as you have probably guessed he needed it the least.

      I fear it is even worse now….

  5. ‘The official story is that low interest-rates are bad for the banks. But if this from @grodeau about Swedish banks is true in the UK which I believe to be so we may have been sold a pup.’

    They’ve done brilliantly well convincing people of their poverty despite the dividend flow.

    • Hi Dutch

      I think the money has gone to repair balance sheets. Of course some are still troubled like RBS and various Italians. Also some bailouts badged as a triumph seem to then have problems. From Thomas Hale of the FT.

      “Santander launches €1bn scheme to pay back retail investors in Popular (as long as they waive right to legal action)”

  6. you have ot admit that they’ve done a brilliant job of preventing a 1930’s style depression and saved all those Banks by making sure the tax payer takes the bill

    and to have found some wizardry to have a majick money tree for the government

    rigged inflation and GDP is just the trick

    but somehow I don’t think they know what to do next , apart from ban cash ……..

    makes you wonder why , don’t it ?

    I think myself that they’re just a bunch of B’Arkers , still with MSM in your pocket , who cares ?

    when it goes all Pete Tong you can always fall back on the ” oh what a surprise ! , no one could have seen that coming !”

    Forbin

    sit back and watch the show, here have a seat on the sofa and help yourself to some popcorn …

    • Yes they have kept the plates spinning Forbin.
      Their coup de grace is the cashless society which means they know everything about you and you cannot survive without them
      Even better if everyone runs for the exits in a crisis then there can be no bank runs if there’s no cash.
      Contactless…the Trojan horse the final piece in the brainwashing master plan.
      Bank slaves of the world unite.

  7. I don’t think rates can rise in the absence of falling ‘real’ debt levels. As you know, interest rates encompass what is known as the “monetary policy transmission mechanism” – so the larger debts are, the more sensitive this mechanism. So changes are made in smaller and smaller increments and absolute levels have fallen to incredible lows.

    Of course, this is all a result of freeing up capital controls which allowed surpluses to be recycled into property and other asset markets rather than trading in balance.

    How do we reduce debts? Well, that is easy – 1. raise rates to cause defaults and debt payments reducing asset prices into the bargain 2. implement a land or wealth tax on assets

    What won’t work on its own is lower and lower rates, or even negative rates – as that just encourages asset backed borrowing and rising asset prices. And, of course, without an interest rate, we don’t actually operate a ‘capitalist’ system whereby private banks perform an essential role in allocating capital to the economy.

    Still a great blog by the way. Regular reader but don’t always comment.

    • “I don’t think rates can rise in the absence of falling ‘real’ debt levels”

      Yes they can provided FX is relatively stable and income levels are stable/increasing. That means aggregate income levels, NOT individual levels. Aggregate income levels have been increasing as the workforce has grown although individual incomes have barely paced inflation. The UK could and should have started raising rates at end 2015..

  8. “This of course was silly on two fronts. Most obviously it ignored the fact that much of Europe and of course Japan already have negative interest-rates and it also led to the really silly expectation of a cut to 0.1%.”

    Silly? hardly, he was talking about the UK and not the EU, Japan, Sweden etc or did you miss that?

    He can’t be held accountable for false expectations created by moronic market participants!

    ” If we switch to wages growth we see that something has changed. If that persists then the real rate versus wages may turn out to be very different.

    You’ve forgotten about aggregate wage growth which has been outpacing inflation for some years now – suggest you look into it.

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