We're all doomed?
One of the great, global, economic forces of our age, which I’ve bored you rigid discussing in this blog, is that it has been possible to borrow long-term money at relatively low interest rates.
For the past few years, the impact of these low long-term interest rates has been visible in a surge in borrowing by individuals and companies together with the related phenomenon of rising prices of almost every kind of asset or commodity. Here are just three important manifestations:
a) UK house prices that keep going up and up – almost regardless of what the Bank of England does to short-term interest rates;
b) share prices, that have increased more-or-less in a straight line since the spring of 2003;
c) a boom in takeovers of companies, financed by borrowing, and a great wave of repurchases of shares by companies, again funded by debt.
Now, a fall in longer term interest rates is simply the corollary of a rise in the price of certain US Government bonds.
And what has kept the price of those bonds high has been two trends.
First, the accumulation of vast foreign exchange reserves by China, Japan and other (largely Asian) exporting nations, which have been invested in US government bonds.
Second, a decision taken some years ago by large insurers and pension funds to become more risk averse, and reduce their exposure to shares while increasing their holdings of bonds.
Now according to analysts, for some years long-term interest rates have been significantly lower than they should have been on the basis of their normal historical relationship with short-term interest rates and the health of the global economy.
Which is why what has been happening over the past few days is important, though largely unreported outside of : there has been a sharp fall in the price of 10-year US government bonds, known as US Treasuries, and thus a precipitate rise in the benchmark price of borrowing for ten years. Yesterday, the yield on 10-year US Treasuries rose to its highest level for more than five years (to 5.27%).
This is much more important to all of us than what the Bank of England does to short-term interest rates.
For example, the rise in these long-term market interest rates pushes up the price of borrowing for our big banks and building societies and will probably feed through to the interest rates on new fixed-rate mortgages.
Which could prick the housing-market bubble.
If those longer-term rates continued to rise, the frenzy of private-equity fuelled takeovers could fizzle – because the cost of financing takeovers would exceed the cash-flows of the relevant target companies.
So just why have longer-term rates risen? Well, one reason is that the global economy is performing too well – which means that central banks are either pushing up short-term interest rates (as they have just done in the eurozone and New Zealand, and probably will in the UK) or are not cutting them (as is the case in the US).
But that is not the significant reason, because that would not signal a return to the historically normal relationship between short-term interest rates and long-term ones.
No, the more interesting reason for the rise in long-term rates is that the Chinese are switching hundreds of billions of dollars out of bonds and into equity-related investments. And there are also signs that other important global investors are increasing their appetite for risk and equities.
That in turn means share prices are unlikely to collapse in the immediate aftermath of the fall in bond prices. They will probably be sustained by the sheer volume of cash being put into stock markets by the Chinese and others.
But there could in time be a seriously negative impact on the price of shares. Higher longer term interest rates should eventually lead to a squeeze in the profits of companies, which would make shares in those companies less valuable.
The bond-market turmoil and fall of last week may turn out to be the beginning of the end of the current upswing in in shares, property, you name it, the possible end of an all-embracing bull market.
And that would mean, to quote Private Fraser, that "we're all doomed, doomed."
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So as a businesman and investor your report is suggesting that my long term investment in a company may not be wise, in light of the potential economic change, which may occur. Will this not trigger a negative response from potential takeovers and major investors? I have always weighed up positives versus negatives, what are the positives that i may consider, against the negatives that you have calculated?
I don't know if doomed, but maybe a correction wouldn't be too bad. The "crash" or "soft Landing" scenarios will depend on just how much we as a nation AND individuals have overstretched ourselves. We do not have the benefit of hindsight so predictions should be treated with caution, but any person hith half a brain should take heed and review their financial position, especially on the subject of personal debt.
But if what you say comes trough to the full extent a bear market is highly likely and many people are going to be stung. More so those who borowed to the hilt to fund consuption.
Good article. Shame about the last three paragraphs.
Risng bond yields and interest rates would put pressure on company profits and hence share prices. This could just dampen share price rises. A soft landing and part of the constant rebalancing of relative prices.
The real issue is = where does the wall of money go? Property, bonds, equities, commodities? Globally property probably has the most scope for inflation and absorption of value.
A more local aspect of this that has been recognised by a very few UK analysts relates to the so-called pensions crisis. If everyone in the UK actually did invest the required amount for their retirement, would markets be able to absorb the cash inflows?
Not yet another ''reason'' for house prices to reverse (prick its bubble). I wonder how many times I have heard this over the last 30 years?
Prices may loose a couple of % - but look where they came from! Β£100k 5 years ago on average and Β£200k now. No-one is suggesting that position will reverse.
Where will they be in 5 years time? No-one knows for sure, but less than they are now? Not likely!
Look at asset prices (including houses) over the last 10, 20, 30, 40 & 50 years why does anyone think the next 10 or more years will be different from every other 10 or more years throughout entire history?
This article is a typical; ''ifs buts and maybe'' report.
At any time over this last 10 years a similar report could have been written pulling together another set of facts and would also spell ''doom''.
We have to move on and carry on.
Interesting article, though you fail to mention that these rising Gilt and UST yields actually paradoxically make pension funds MORE likely to buy bonds, depressing yields once more.
The reason is that a rise in the discount rate has a bigger impact of a pension funds funding position that rising equities do - therefore there is a real risk that pension funds derisk some more, sell equities and buy bonds.
Of course, that scenario is not necessarily good for equities either!
It's a trade-off for me at the minute - being old-ish and thinking of drawing money from a money-purchase pension scheme - the value of my pension is dropping with the plunge in share prices, but the value of the annuity I can buy with it is rising as a result of rising bond yields. I'm not, however, happy - I'd rather see high share prices.
Great article, but perhaps not taking the analysis quite far enough. Rising cost of debt will dent company profits in the short term, but the debt and equity markets have a supply side too. The logic of debt financed PE take-overs and share buybacks reverses, and IPOs, share issues and bond buy-backs will help to meet the shift in preference from debt to equity. The total cost of financing depends largely on the total supply, and as long as China and the Middle East does our saving for us, the finance will be there.
However, there is one very large sector of the economy that is not quite as flexible: private individuals cannot issue equity in their houses to cancel out debt. The dent in their "profit margins" (disposable income) affects the economy as a whole, which also means the profits of companies. Only the "IPO" route is available, which means selling, so the process by which their balance sheets are adjusted happens at the transacting part of the property market.
However, this could be the point when you discover that your equity isn't worth nearly what you thought, and you haven't actually saved very much at all for the last 10 years. For some it could mean their REAL gearing ratio is way over 100%, ie. negative equity. The painful process of repairing the developed worlds personal balance sheets means more saving, less spending. Unless the Chinese take up consuming like there's no tomorrow (which somehow seems unlikely), this is the real bad news for companies and individuals alike.
I really don't think you need to go to such an extent to show that the wheels are about to come off the UK economy! If you add all the UK foreign debt together from all sources (government, personal debt and company debt) it adds up to Β£10trillion [CIA figures]. Thats actually greater than the Β£8trillion owed by the US. Ireland, Holland and the UK are in this position, and all have had booms prompted by extremely low interest rates in historic terms. We are now up to our armpits in debt and our total GDP cannot easily service the interest on our total debt, so it must be the case that interest rates rise to choke off the increase in debt. This will reduce the money supply that we have had due to increased debt and plunge the economy into serious recession. We will have a massive mountain of debt but will lose the means to pay off the debt. We are indeed doomed.
Someone has to gain from all this gloom. I've held off switching my personal pensions (invested in equities) into annuities because their Bond-driven yields were too low. Yields are improving now (good), but there's probably quite a bit more to go (even better). Judging my switch to when equity price rises and Bond yields have each levelled off is going to be tricky. Any ideas for how we'll know when that will be?
Cheap loans are great fun until the lender wants their money back.
If the Chinese are now starting to ask for their money back, then that's ominous for our spend spend spend economy
The conclusions drawn here seem a little difficult to sustain, for example that the Chinese moving billions into equities could lead to the collapse of the equity markets, or that a rise in long-term rates is indicative of future rises in short term rates, along with the consequent effect of company profits.
While the latter point reflects a time-honoured view of the interest rate markets, one point of the article is that this model hasn't applied for a few years because of large capital flows. So, there is no reason to suppose that it will return any time soon.
Overall, though provoking but not convincingly reasoned.
Phillip Hoy states that "UK foreign debt adds up to Β£10trillion and is greater than the USA foreign debt" are both staements correct?
Low interest rates and low inflation could have been a genuine benefit to the UK economy resulting in higher investment levels in high growth start-ups and other genuinely economic growth related areas.
Instead - being British - we chose to do entirely the wrong things. We let house prices soar, grew ourselves a balance of trade deficit the size of the GDP of a small country, allowed household debt to create new records and invented Private Equity as a means of making oodles of money without actually creating anything new and sold most of our industrially strategic industries off to our competitors.
Frankly I'm in favour of interest rates rising to at least 10% to kill all these things off. It's no less than we deserve for our utter stupidity.
A good article, and you are right to "bang on" about it; it's true that the treasury bond rate did briefly touch 5.15% in May of 2006, a jump from 4% or thereabouts of the year before and the markets seemed to defy it all. Now, with respect, consider; house prices have risen expotentially (my house has gone up in value by three times and I haven't done anything to it), stock markets as well all on the back of cheap money. Chinese citizens are piling into their market, no firm of any size is safe from takeover (or take private), and everyone buys US treasury bonds. This is all thanks to globalisation and the spread of risk but no one knows who has the final risk. Lending is getting more desperate (cf the sub-prime market in the US). Where will it all end, because as they say in all those saving plans, what goes up cannot go up for ever, whether in relative or absolute terms.
Yes, as ever this doesn't really look at the full dynamic.
The US is haemorrhaging capital simply because it is a bad financial risk. In the past the US has got away with a great deal because as the World's only economic superpower, the dollar has enjoyed a privileged status. Those days are now gone and US dollar exchange rates are going to have to reflect market fundamentals.
The bottom line is the US is consumer driven economy based on debt, and those are not sound fundamentals for a strong currency. Capital flight is taking place as US Corporations are investing in plants with better unit productivity in China and India, and also to establish a foothold in the World's two fastest emerging economies. Foreign investors are getting cold feet as they see a growing risk of having all their earning wiped out by a depreciating currency. The problem is that fear is self fulfilling. As investors pull out the currency will drop. Interest rates will be forced much higher to prevent inflation but also to stabilise the dollar.
The bottom line is that US Technological advantages of the last twenty years are virtually spent. The advantages of holding the World's reserve currency have been squandered. The US is going to have to graft for its living just like everyone else. The question is, are the equipped to do this, and do the current generations have the grit to turn the thing around.
Take yourselves back to Britain in the late 1960's and early 1970's. It took years to forge the political will to put things right. Even when Thatcher took a butcher's axe to everything it took two decades for real benefits to flow. This is not going to be easy, but it is substantially a US problem. It may well be that other will benefit from the capital flight and therefore enjoy firm currencies and lower interest rates. This is not the end of World economic growth but it is the end for the virtuous circle that the US has experienced.
I am fascinated by the unrelenting optimism of some who support the idea that we will have ever higher house prices. They seem distracted by nominal gains - just because the nominal price rises over 5 or 10 years does not mean its a good investment - particularly if taxes, maintenance and high interest rates all take their toll.
What is also interesting is the number of properties in our area that are both for sale (and being marked down to sell) and for rent at the same time - (a quick scan using Rightmove makes for an interesting half hour) - either the owners can't make up their mind - or they are at the mercy of the market and desperate to fill or sell. I am particularly interested in the glut of modern apartments that no one seems to want.
Presumably that wall of investment money could also shrink if the Chinese start consuming more and central banks slow the printing presses?
I notice that gold prices have dropped steeply in the last two days. Is this connected with the fall in UST's?
Robert Peston speaks of Pte Fraser, and says "We're all doomed".
I prefer to quote Corporal Jones, and say;
"DON'T PANIC! DON'T PANIC"!
No, you are NOT doomed.
You just might have to go out and work for a living.
Does this mean the end of newspaper stories everyday telling me that Blackstone or Permeira or KKR have bought everything in the country? Thank god for that!Asset stripping vultures!
Will a normalisation of long term and short term interest rates necessarily lead to economic disaster? I think that is questionable. However, if it happens at the same time as a significant rise in both to curb inflation then answer is most likely yes.
In terms of the impact of the fall in US Treasuries, i would argue this will simply exacerbate the changes already occuring in the market. The level of household debt is already on the wane, as people's expectations are that Bank of England interest rates, which is what the average person is focussed on, are on the rise. Expectations are already of higher (short term)interest rates at circa 6% by the end of the year and rises in US treasury yields will simply reinforce that expectation.
In terms of bursting the asset bubble in property, equities and other assets, again i think the writing has been on the wall for a while. Anthony Bolton's recent comments on the take over frenzy has refocussed a few minds in the City. Speaking to my local estate agent the property market has definitely started to cool in London with fewer buyers walking through their doors then at the start of the year and this is being reflected in fewer mortgages being approved. Globally the collapse of the sub prime market in the US and the problems being experienced in Spain and elsewhere show that the residential slowdown is in full swing.
All in all I would say that the markets are already factoring in tighter monetary conditions. Are we doomed? Perhaps not yet, as we need to see how long these conditions last and how far they go. However life is going to be a bit harder over the next 12 months then they have been recently.
are we not too much obsessed with rocketing housing market and private equity funding - no doubt both have gain from low interest rate but lets try to put things in another perspective -- this is the first time in the human kind history when we are enjoying so much money, resources and growth due to the open up of China, India, Russia and Brazil markets -- so lets try to think about a global world with so much resources and in fairness how everybody can use it ..
Well, things never quite work out as good nor quite as bad as we expect them to!
currently the housing market will remain strong because of demand (growing number of households and limited supply of new development) unless higher unemployment were to reappear. This would happen approximately 1-2 years after any significant and sustained rise in interest rates reducing business profit. Interest rates only rise if higher inflation is sustained.
Higher rates will make buy to let property unprofitable and cause sales of first time buyer properties, and unemployment will weaken a depressed housing market further and reverse the trend for economic migration if our economy goes down the pan.
However, our rate of inflation only needs to be maintained around 2% because of Treasury decree. This absolute will alter if world inflation increases, meaning that we can release our tight grip on this inflation target if world rates increase. We need to ensure that UK plc is competetive in comparsion not isolation and wouldnt a litte inflation help to reduce everyone's mortgages in real terms ?
I think the title of the article ought to be 'We are not all doomed, just yet...' Looking 3 or maybe even 5 years ahead though and given the current trends taking hold (private equity buy-outs, IPOs, persistent world-wide property bubble etc.) one surely has to be convinced of impending doom (probabilistically). When exactly it is to play out is another matter and I think the prediction above may be a bit premature. There appear to be such powerful monetary forces at work currently that it might take a lot to reverse the bull trend; just imagine how much has and is being made with ~$70 oil and the effect that money has when fed back into the very economies that caused and currently sustain ~$70 oil (it is surely greater than the 5% charged for the debt feeding it). Think of London; newly wealthy individuals (city and foreign) buy up expensive central property, the ripple effect extends to elsewhere in the country and beyond even into other countries and to people who can ill afford to borrow at 5 times annual income, let alone spend it on an investment now arguably not risk-free. Add to this the fact that real interest rates are still very low, even after the recent hikes, and you have a recipe for ever-increasing greed and risk. We're in certain bubble territory to my mind (remember dotcom fever anyone?) and from memory the only way bubbles end is with a loud pop. Any other disturbances tend to be ephemeral and simply invite others to join until finally the "liquidity" just seems to disappear like a mirage leaving all in disbelief. Central banks appear to be following the curve; to really stop this deliberately they'd have to get ahead of it and raise rates more aggressively closer the 10% level someone mentioned earlier in this thread. I suspect this is not really in their interest though (given current trends) so I would expect inflationary effects to relentlessly tick upward with rates in tow. Back to the 70s.
Simon #3, I thought the point of the article is that the wall of money is switching into equities?
Phil #23,
Unless your interest rate is fixed for the duration of the mortgage, higher inflation will not help you. Lenders are not naive, they demand compensation for the mortgage erosion that inflation causes, and then something extra on top for the increased inflation risk introduced by such dodgy monetary practices. So 1% increase in expected inflation means 1% increase in nominal interest rates, and then some. Of course, over time your salary will increase by a bit more relative to your mortgage, but so will prices. Eventually it cancels out, but only over time. In the short term, if your finances are stretched, they will be even more so with higher inflation expectations
anyone helps me understand why Dow Jones has now bounced back and since then, nearly all indices are in green?
obviously there is something out there saying: Robert, you might be wrong.
p.s. Thanks to this volatility, I gained a small profit in spread betting. I am sure lots of people in the City are also having a good time.
I must admit that normally I'm not your biggest fan, as I find some of your articles a bit like a cappuccino - more froth than coffee. But this article was excellent, and like a refreshing wake up cup of Yorkshire tea. Can we have more like this ?
People have been living in a fool's paradise, and on borrowed time, since 2001. Huge amounts of borrowing which is not really prudent looking at long term views of interest rates, often to spend short-term spending such as cars.
But I'm not totally convinced on your view about shares. Some shares, such as Lloyds TSB, have been relatively sluggish in the last few years, so I don't think they have necessarily got far too fall.
A correction to bond prices is long overdue. There will be winners as well as losers. An increase in interest rates favours savers over borrowers and so will help pensions and cash rich companies (not all companies, borrow heavily!). In the long run, change is healthy.
Strategically the UK worker will compete more directly with workers from China and India. Bringing down our standard of living and reducing Government services. How will this happen? Will wages fall or inflation rise for this realignment. That is a problem for the BofE.
China has bought dollars and has artificially reduced the price of it's exports by manipulating its exchange rates, by between 20% and 40% - depending who you listen to.
When the Chinese exchange rates rise it will cause a rise in the cost of imports. The BofE will eventually have to decide whether to let inflation go up by leaving interest rates low, in which case inflation will eat away at wages. Alternately it may want to try to dampen consumer demand by raising interest rates and dampen wages. This second strategy will only work if you assume dampening demand will reduce the price of rock-bottom priced imports. SO it looks like inflation will come back - eating away at house prices.
Predictions by Adam Smith on a rise in the wealth on nations didn't account for a near unlimited supply of cheap labour, globalisation and a limited or falling supply of raw materials. If he did take them into account, he would have predicted falling wages and the price of goods rising.
What is happening should have happened long ago. This 'conundrum' has been there for the last few years. US has been selling IOUs - Chinese, Koren and Japanese were happily buying these papers(Treasuries). Only recently Chinese have woken to asset management. Note –Chinese central bank recently invested in a risky asset class - private equity(Blackstone). This is just a beginning of an avalanche. As soon as the central banks in Asia realise their investments will be worth lot less unless they switch to other asset classes, the real avalanche in 10yr paper will begin. As more and more banks move out of treasuries, yield will continue to rise. Eventually the US treasury will be forced to issues short term paper instead of 10 year paper, then you will see the rise of the short term yields.
We are not doomed. Whenever or wherever
there is doom there is also the birth of a new boom.
In other words, when something is going down something else is going up.
The big question is where's the next big boom happening?
1. The uranium mining shares.
2. Small cap exploration companies
3. Gold and silver.
Well I am lost by all alegations and counter allegations above. I am becoming more convinced by the day to pull out of our Shares ISAs and put the money into untaxed savings accounts for now (National Insurance), until a new cash ladder appears (we rode the current footsie climb (3.2k to now 6.7k).
Thank you for your article. In the midst of all this one must remember the principles applying to the behaviour of all markets. Markets have no memory. Markets rise or fall solely according to the weight of money going in. Markets continually climb the wall of worry and greed. The only history worthy of note relating to markets is that they always overshoot and undershoot at times. War or political turmoil is bad for financial markets, yet can provide outstanding buying opportunities. The best time to buy is when 'blood is on the streets@ (Warren Buffet).
There is undoubtedly a change. Suddenly China and some other net holders of currencies have realised that to continue proping up the dollar by buying U.S. Tresasuries is a one way bet to loose value. What will they do with these huge balances? There will be a wall of money heading for the equity markets and some of the cash will also be spent on riskier bonds. The Chinese are amongst the worlds greatest gamblers and really the default rate amongst junk bond issuers is incredibly low at the moment. As long as this happens everything will be just dandy.
so it is better to swicth my money in mutual fund that invest in bond than mutual fund that invest in stock because the cost of borrowing is increasing .
Sure 'julie' has a point- I have read down to her number 34, and whilst indeed interested, I am more confused about financial investment than ever, due to the extraordinarily complex issues that have a very significent effect upon monies invested and the worldwide price of eggs.One can only hope that more sense is printed in the previous bloggs than nonsense.
How to tell?????
Bruce Shaxson.