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It’s a scary world out there

What are the implications of central banks and policy makers having no ammunition when the next economic downturn hits?

In the current low interest rate environment it seems incredible to remember that the US federal funds rate (the equivalent of South Africa’s repo rate) was at 20% in the middle of 1981. The Federal Reserve chair at the time, Paul Volcker, had decided that high inflation had to be tackled, and he did so by strangling the supply of money.

High interest rates were in fact a feature for most of the early 1980s, being above 15% in the US for most of that period. Even in Japan they were close to 10%, and in double digits in the UK.

From that point, however, rates have been declining. By the turn of the century they were at, or close to 0% in much of the developed world.

Since the global financial crisis some countries have even seen what many economists once thought impossible – negative interest rates. In places like Japan, people had to pay the bank to hold their deposits.

This has, understandably, caused the opposite of what Volcker achieved back in the early 1980s. Since money has been incredibly cheap, countries, companies and individuals have taken on high levels of debt.

Impact on returns

This has been one of the major causes behind the global economic expansion we have experienced for the better part of the last half a century, since it was easy to raise capital. Rapidly rising populations in most of the developed world also increased production levels, and therefore economic output.

Interest rates cannot, however, keep going lower and populations across Japan and western Europe are not only ageing but, in some places, declining. As John Stopford, head of multi-asset income at Investec Asset Management, points out, we are entering a very different environment.

“The leverage cycle that we have been through over the last 40-plus years, together with demographic tailwinds that have been behind global growth, have been very important drivers of financial market returns and asset growth,” he says. “Potentially, however, we are at an inflection point for both.”

As monetary policy inevitably starts to tighten, what are the implications, not just for growth, but for investment returns?

Falling interest rates have consistently pushed up bond prices for decades. At the same time, strong company earnings have supported equity market gains. More recently, quantitative easing (QE) has delivered even more cheap money.

When the wheel turns

“The danger in financial markets is that we have all benefitted,” Stopford points out. “If it all starts going in reverse, that has significant implications for growth, interest rates, and asset returns.

“We are now entering an interesting point where central banks are starting to take away the punch bowl,” he adds. “QE hasn’t just pushed up equity prices, but the price of everything, and it has pushed yields down. If that reverses, how does that undermine asset values in the short and long term?”

At issue is the conundrum that central banks will face when the next economic downturn hits.

“In the short term you have a cyclical set of forces pushing treasury yields higher,” Stopford notes. “It’s very late cycle in the US with low unemployment and inflation starting to show its head. Historically the Fed has tightened until something breaks, until there is a recession.”

There have been no instances of the Fed raising rates, then allowing them to stay constant, and then raising again. When the recession comes, rates get cut.

“The big problem for us is that in historical cycles the Fed and other major central banks have cut rates by 4% to 5 %,” Stopford points out. “But if they are only able to push them up to 3% this time, the US has to become creative. In Europe, I don’t think they will ever be able to raise rates. So what are they going to do? A lot of the levers that were pulled last time, they are not going to be able to pull again.”

The broader consequences

If monetary policy can’t be used to stimulate economies, how are governments going to respond? It’s unlikely that they will simply be happy with a protracted recession. That may leave only the option of taking on more debt and inflating it away.

“There are really three scenarios,” Stopford believes. “Managing to have more of the same is the most optimistic. That means looser policy than we are used to in the past and reasonable growth globally. But that will almost certainly mean periodic asset bubbles as central banks have to keep supplying cheap money.”

The other two are less appealing, but also possibly more likely.

“If you have too much debt and growth that can’t support that debt you either have a default or inflation,” Stopford says. “Central banks and policy makers would probably choose inflation.”

That, however, has some potentially much broader and unattractive consequences.

“I think we are just seeing the beginning of populism,” Stopford says. “Typically these kind of end-of-era financial events, where you see high inflation or debt inflation, end in armed conflict. Hopefully the world is more sensible, but when you look at Trump, populists in power in Italy and fascists gaining influence in Sweden, it’s a pretty scary world out there if you take a 10-year view.”

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Strange that our economy is doing nothing but the rates remain high! Captured.

Yeah. We are stagflating which is a whole different type of beast and one which our parliamemt in particular is entirely unequipped to deal with.

Actually our interest rates are incredibly low at the moment compared to our own history. If you look at the Reserve Bank website you’ll see times when our repo rate was c.15%+ versus the current 6-7%.

Correct, you are. And we are behind the curve in raising interest rates. For our banks to borrow money overseas is going to cost a lot more. Their interest rates are climbing.

Days of cheap money are over.

There is a global financial crisis occurring under the radar. GET DEBT FREE PEOPLE!! Once we go to junk, the interest rates will spike. I wouldn’t buy a home or make any big debt purchases now. You have been warned.
Joe (aka Dr. Debt)

I principal I agree completely with you, in a rising interest rate environment, you want as little debt as possible, but like the observation Sensei, Warren and I made rising interest rates and devaluation of the currency is almost like having your debt forgiven, that is if you had a bought something like property or something that has intrinsic value.

E.g: If a Venezuelan borrowed money 6 years ago to buy dollars at 1USD = 6VFD the interest in the past 6 years averaged around 20%, but the currency has lost over 130000% of its value, going into massive debt back then would have been the best decision you could ever make.

The question I now sit with, is do I make more debt as well in anticipation of currency devaluations coming?

PJJ well said. The way I see the answer to your question is “cash-flow is king”. One should take on the maximum amount of gearing that you can service out of the cash-flow. Inflation diminishes the value of debt, but we must be able to service the interest. Farmers who bought property during the 80’s, burnt their fingers when interest rates went to 28%. Although the farm increased in value, the income could not service the higher interest rates. The solution would be to sell small parts of the farm to service the debt, but the law prohibits the subdivision of economic farming units.

To my mind, one way to profit from rising inflation, rising interest rates and a weakening currency is to borrow in dollars at interest rates that are 70% lower than in SA, and use maximum gearing to buy listed instruments in the USA. There is zero currency risk, you borrow at the lowest rates, a weaker rand is in your favour, plus the rising inflation consumes the value of your debt. There is no requirement to repay the principle, and it is effortless to liquidate part of the position to service the interest.

This is an extremely risky option for a person who is not a professional trader and I do not advise it at all. To be honest though – individuals who gear themselves in property are taking on the same amount of risk. Property investors are unaware of the fact that they are merely using the bank’s money to speculate in the bond market. The direction of the property market is a function of the direction of the bond market.

So, who is taking the highest amount of risk? The trader who is aware of, and actively manages his geared position in listed instruments, or the property investor who is not aware of the fact that he actually owns a geared long position in the bond market, disguised as a house?


Thanks for the great reply.
I am also not a professional trader, or well any kind of analyst or trader for that matter, I also don’t have any tertiary financial education.

But I don’t know, the solution seems so obvious to me, but like I have learnt the hard way with the few investments I have, is that, its often the trades you are the most sure of that turn around and bite you in the backside…

This article had measure to some degree but failed to mention debt in China

The last paragragh? Reflects Stopfords benign naivety and hysteria. Had he included extreme populist socialism as in the implosion of Venezuela, the article read would have had much more consequence after thought

I visit Moneyweb to read quality articles like this one. Thanks Patrick.

Bond prices in the US recently ended a bull market that lasted for almost 40 years. Interest rates have been in a steady decline over this period and the Dow Jones Industrial Index rose by 3200%. At first glance, we could say that the declining cost of capital and cheap credit supported the rise in the equity market. Over this 40-year period, we also experienced 3 serious financial catastrophes. We had the “Black Monday” crash of 1987, the Dot-Com Bubble in the year 2000 and then the Great Financial Crisis in 2008. These declines of 30% to 50% took place in this environment of lower-trending interest rates. It is clear then, that the movement in the Fed Funds Rate per se, does not determine the trajectory of asset prices. There is another, less visible driver.

The Fed Funds Rate, relative to the rate of inflation is a more accurate description of the cost of capital. Inflation, caused by a growth in the availability of credit, is the strongest driver of long-term bull markets. The yield on the 30-Year US Treasury Bond is the correct inflation-rate as seen by investors. The recent rise in the yield on the longer-term maturities actually confirm that inflation is picking up. As long as the cost of capital (Fed Funds Rate) is lower than the yield on the 10-Year or 30-Year T-Bonds, it implies that the cost of credit is lower than the rate of inflation. If the cost of capital is lower than the inflation-rate, it means that credit is free of charge. We can experience rising interest rates in an environment that is still “accommodative”.

It is when the yield-curve inverts, when the price of credit is higher than the rate of inflation, when credit has a positive value, that the market hits a brick wall.

Its strange that people knock on doors, yet never enter nor is the gargantuan pachyderm in the living room acknowledged. The root of the problem is the monetary system that the world has adopted. Money is debt. All money is created by an act of borrowing. Since the interest on the debt is never created, there will always be more debt than money. When some of the debt is repaid money is destroyed. However, we have all heard of the magic of compound interest. The flip side is someone owes that debt. That debt is compounding in exactly the same magical way. One day soon, all the money will be sucked out the global financial system to service this debt and it will all come crashing down like it did in the GFC. One can never get rid of the debt as creating money to pay it off incurs more debt. The debt is irredeemable.

There are some serious errors in the article. Principally that the central bank or Fed in the US is in charge. They can make things happen. The fact is that interest rates are a market phenomenon. The only influence the Fed can have is to buy or sell securities. If the central bank does not raise interest rate when they are rising, the currency is toast. If the central bank does not lower interest rates when they are falling, the economy is toast.

What is interesting is that in the 1970s interest rates rose to dizzy heights then fell over almost 40 years. The destabilisation of interest rates in the US was simply due to abandoning the gold standard. The gold standard was a stabiliser of interest rates. When interest rates were too low for the prevailing environment, people flocked to gold. If interest rates were too high then interest bearing paper was preferred. Thus being able to exchange US$ for a fixed mass of gold stabilised interest rates not prices.

There is another upside to a gold standard. Gold is the form of money that is nobody’s debt. Thus one can expand the money supply and pay down debt at the same time. Gold is the ultimate extinguisher of debt. Thus the debt monster is contained.

The period from 1980 to present coincides with the de industrialisation of the USA and this is not coincidental. Falling interest rates destroy industrial capital. As interest rates fall, the value of bonds rise. The gain of the bondholder is reflected in the increase in the retirement value of the bond which literally eats the capital of the company. Even if the company is ungeared, it financed its plant and equipment at too high cost of capital. It cannot compete with newer entrants financed at lower rates. In fact, the smart thing is to not invest when rates are falling.

The fact is most financial “experts” will never acknowledge the problem as interest rate speculation is an opportunity to transfer capital from the industrial sector to the parasitic financial sector. They prefer to blame greedy bankers and irresponsible lending to fessing up to the real problem. In the interim central banks keep kicking the can down the road feeding you popularist nonsense about Trump and the rise of the right wing fascists in Sweden (folks who merely treasure their culture). Therse guys are the real ‘swapmp’.

But the US debt clock has been on an infinite treadmill for decades now. Everytime they hit the wall they borrow more. Why is it different now? Is it a function of removing US reserve currency status and Trump the catalyst per the EU’s correspondence of removing USD dependency for likes of Iran?

As an aside, what’s the alternative at this stage? If the debt implodes, the only assets worth holding are canned beans surely?

You describe the situation perfectly. The fiat currency system is a “Goldilocks” monetary system. It is simply to good to be true. The USA abandoned the gold standard because of the fact that they were responsible for the issuance of the reserve currency under the Bretton Woods agreement. The “Triffin dilemma” explains why they had no alternative, and were forced to “default” on the Bretton Woods agreement. The USA simply printed more dollars than the gold they had as backing.

What readers may find interesting is that after the “Nixon Shock” of 1971, it was illegal to quote any price in terms of gold! Gold in private hands was confiscated and private ownership of gold was banned.

This simply confirms the statement of Richardthe Great. The USA had to ban ownership of gold and all value comparisons in gold because the government needed to devalue the dollar, in order to save the US economy from bankruptcy. The rest is history, as Richardthe Great describes it.

The current international Fiat system in not sustainable, just as past Fiat currency systems were not sustainable. The current system will implode in the form of a banking crisis. The Reserve Banks of the world may devalue and print as much as they like, they may succeed in kicking the can down the road for another 100 years even. Eventually the gold standard will take over again.

In the mean time we should understand the game and play it to our advantage. In a Fiat currency system, where credit expansion is the name of the game, the investors who are “nearest to the source of the newly created money” become wealthy, while those who are “furthest from the source of the newly created money” becomes poor.
(Von Mises. Von Hayek. Prof Huerta du Soto)

@Sensei. Eager to learn. How does an investor position themselves “nearest to the source of the newly created money” at times such as these? A shift to US stocks? US currency? Tech stocks? Or new currencies such as crypto? Keen to read your thoughts. How do you balance the opportunity to seize an advantage with a desire to defend the wealth you have already built?

@Cassian I definitely don’t have all the answers but I try my best. 🙂
The statement that “those closest to the newly created money become wealthy, while those furthest away become poor” is a part of the Austrian Economic Theory. This is the only economic theory that accurately describes the root causes of perpetual cycle of bull markets and the unavoidable economic crises.

To explain the statement – let’s go back to the time when Spain was the world power that the USA is now. Spain was on the silver standard. Silver was money. People transacted with silver coins. Then the Spanish conquistadors discovered a mountain of silver in Bolivia. The mountain is called Potosi. More than 4000 people died while mining for silver. What happens to the value any currency when new currency is ejected into the system? Before the Spanish discovered the silver mine, inflation was under control and the silver coins held its value over time. When the newly-found silver reached Spain, there were more silver coins chasing the same amount of goods and services. Inflation of the money supply caused the decline in the purchasing power of a silver coin.

When the captain of the ship that carried the cargo of newly-found silver, reached Spain, he could still buy products and services at the “old” price. He had an abundance of new “money” with him. He paid his sailors higher wages in silver. These sailors with the abundance of newly-created money went into the harbour town to visit the pub. They ordered beer and women at the “old” price. After a while the beer and women were out of stock because of the high demand created by the availability of the new money. The owner of the pub and the ladies raised the prices because demand was high and stock was limited. Products became more expensive for everybody in the city who carried the old silver coins. The sailors who were paid with the new coins had an abundance of coins, so they could keep on bidding prices higher. The owners of the ship, as well as the sailors and the captain were wealthy, while those who were last in line to receive the new coins became poor.

This is exactly the scenario under a Fiat currency system. In order to save the financial system, the US Fed increased the money-supply four-fold in short period. As signaled by the rise in interest rates in the USA, the ship with the new silver has only docked now. Inflation is picking up. The American stock market is flying, while Emerging Markets, Europe and the rest of the world is lethargic. This newly created money will eventually work its way through the system, as we see in the recent rise of the local resource sector. The resource companies enjoy bigger margins when inflation kicks in.

American companies are closest to the newly created money. They borrow at very low rates to buy back their own shares, and to employ more people. This “malinvestment” supports the US indexes. The US farmer has access to cheap and abundant credit. He can produce at a lower price than his South African competitor can. The US farmer, with his abundance of new money, pushes up the price of fertilizer, implements and fuel. The South African farmer, who is furthest away from the source of the newly-created money, becomes relatively poorer.

Thanks Patrick. As Sensei observed…a quality article with global factors inter-playing.

Sir Patrick, I nominate you for Editor-in-Chief! (or Managing Editor)


On another note: if I call recall, just leading up to the US subprime crisis (in 2008/9), international price of oil was way above $100pb. Adding more fuel to the existing debt crisis, by increasing cost of transport & dealing a blow to economic activity. This is another factor to consider, as Brent is over $80 and edging upwards.

To play Devil’s advocate, money is merely a measure of exchange and has no intrinsic value so no backing reserves are needed ( gold, silver or what ever) in theory. The value of the currency is determined by the reputation of the person who controls it and that, together with some hard assets backing it, will give traders the confidence to use it to sell and buy no matter what asset they trade in. So it is less likely to be effected by the silver example Sensei uses and should be a geater stabilizer of trade.

Thank you for the post. If you isolate the means of exchange (Fiat currency, gold coins, shells, beaver pelts or gold standard) in the short term, say a day or a week, there is no substantial difference between them, other than that the paper currency is the most convenient to carry around.

The difference arises when you worked for 40 years and saved your money over that period to fund your retirement. If you saved your “money” in the form of bearskins, gold, silver or paper money backed by gold, you will be able to afford an acceptable standard of life in retirement. The reason being that the availability, the amount of these “tokens” are limited. A person has to risk his life to skin a bear or to mine gold and silver. Many people died in the process of “creating” this currency.

Fiat money on the other hand is produced with a few strokes on a keyboard. @Richardthe Great explains the process in detail. It is the sole purpouse of any Reserve Bank to create Fiat currency at the maximum rate the voters will allow. That is why the rate of inflation is more than 6% in South Africa and less than 1% in Europe. The new money created by the Reserve Banks and the money multiplier of the banking system leads to a loss of purchasing power of the Fiat currency. If you inherited R30 million on deposit in the band today, and you had to live on that amount for 30 years with an inflation rate of more than 6%, you will need a SASSA grant to survive the last few years.

The moral of the story is the following – If people risk their lives in the process of creating the currency, your livelihood will be secure. If the currency is created out of nothing, your livelihood should better not depend on it.

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