Low interest rates are distorting capital markets, raising investment risk and postponing days of reckoning for investments both private and public. The industrialized world is seemingly locked into low single-digit interest rates on government and senior corporate debt. And there’s little awareness of how seriously low rates distort investment flows.<\/p>\n
Central bankers admit they are worried that, if there is another shock, their ability to use normal monetary policy would be limited. The normal reaction to a recession has been to push interest rates down just short of negative interest territory. The Bank of Japan, it should be noted, currently has a minus 0.05% rate on its 10-year bonds.<\/p>\n
You could call persistent low or negative rates engineered by central banks a way to sustain or generate economic growth, but that only works as long as the rates are below the rate of nominal GDP growth, explains Andrew Grantham, senior economist at Canadian Imperial Bank of Commerce (CIBC) in Toronto. GDP growth in major markets is in low single digits. Or less. Japan’s GDP growth rate is zero, Britain’s is 2.1% and the whole euro area is 1.2%, with Italy’s annualized GDP growth at 0.1%.<\/p>\n
To be sure, low rates are good for folks who want to buy a house, but they distort capital markets, public spending and investment decisions. For the broader economies of the developed world, and especially for the developing world, low rates that do not cover the replacement cost of capital goods, market risk or just the value lost by deferring consumption, do major harm.<\/p>\n
“Low interest rates make capital projects look better,” explains Derek Holt, vice president and head of capital markets economics at Bank of Nova Scotia in Toronto. The net present value of projects, which is cost discounted by the interest rate, rises as interest rates fall. “Many projects look good when the cost of finance is 2% but they would not look good at 6%.”<\/p>\n
Low rates make marginal capital projects feasible, which might be a good thing in terms of socially useful but not very profitable investments. Also, by lowering the discount for returns over time, low rates extend the period for debt repayment, Holt adds.<\/p>\n
That means spending on infrastructure spending, such as roads and bridges, can wind up being forced onto the budgets of future generations. If the bridge or highway serves well in future, that could be a fair tradeoff. But it does not necessarily work that way, especially if depreciation is part of the calculation.<\/p>\n
With bottom-hugging rates, corporate treasurers borrow cheaply and buy back their companies’ shares. Buybacks increase earnings per share but may do nothing for the productive capability of the business in question.<\/p>\n
Low rates also cause a form of capital market optimism, explains Don Forbes, a financial planner at Forbes Wealth Management Ltd. in Carberry, Man. “Companies may overborrow at low rates or at least be less careful in scrutinizing returns from projects. Moreover, a low horizon for paybacks can make good projects seem excellent and excellent projects too good to fail.”<\/p>\n
In fixed-income markets, low rates make people reach for yield. That can work out badly. The Bernie Madoff fraud was based on a promised sustainable 8% return. The books were cooked, of course, but the demand for 8% was also a demonstration that investors in fixed-income were starved for alternatives.<\/p>\n
In terms of growth expectations, low rates can cause a perverse result, Holt adds. “If it seems that increase of sales or profits or other measures of growth will be weak for some time to come, companies may be inclined to give money back to shareholders. That is easier to do and to stop than investing in capital projects that are hard to reverse.”<\/p>\n
Last and most important, very low interest rates not only encourage investors to take on more risk in lower-grade bonds that pay more than senior, investment grade bonds, but they also push investors to take equity risk, notes Chris Kresic, head of fixed-income and asset allocation for Jarislowsky Fraser Ltd. in Toronto. “When the S&P dividend yield is above the bond yield, stocks look more attractive,” he says. “For most of the past half century, corporate dividends have been below the 10-year U.S. Treasury bond yield. Today, the numbers are close, with the 10-year bond paying 2.60% and the S&P stock yield at 1.95%.”<\/p>\n
A return to higher rates on trendsetting government debt is not in sight, Holt says. “The lower the rate is and the longer time it prevails, the more borrowers, especially governments, need to raise rates. Governments wind up with more debt than they can carry without very low rates.”<\/p>\n
Debt payback will eventually need politically unpalatable higher taxes. Negative fiscal measures may reduce economic growth.<\/p>\n","protected":false},"excerpt":{"rendered":"
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