The unwelcome consequences of lower for longer

Extraordinary monetary easing was essential a decade ago to reboot the global economy, but continuing to apply emergency measures has placed a huge burden on the private sector and could prove deflationary the longer it goes on. Different remedies are urgently needed, argues Euan Munro.

3 minute read

Euan Munro

The actions of central banks have fuelled financial markets for over a decade. For a large part of that period, those actions – including keeping interest rates at or near historical lows and massive bond purchase programmes – played a vital role in mitigating systemic risk and sowing the seeds for economic recovery, first in the United States and subsequently Europe.

However, the market’s continued reliance on central banks to save the day is misplaced, despite fears of a global slowdown. Beyond the limited effect additional monetary easing will have in stimulating economies without appropriate fiscal stimulus, policymakers must also consider the lasting damage the lower-for-longer interest-rate environment has had – and will continue to have – on the private sector and individual savers.

Painful side effects

Central banks transgressed when they expanded beyond adjusting short-term borrowing rates and began putting pressure on longer rates through the acquisition of longer-dated bonds.

What is often overlooked is the sheer scale of liabilities that low long-term bond yields have placed on the private sector. Many ordinary companies promised their workforce a pension over the last five or six decades – and were exposed if they had not fully hedged their interest-rate exposure.

When long-term rates fell, the promises small and medium-sized businesses made to their employees became a noose around their neck

When long-term rates fell, the promises small and medium-sized businesses made to their employees – often through industry-wide pension schemes – became a noose around their neck.  

Individual businesses may not have fully realised the financial commitment they were making in the first place, but artificial demand from central banks to keep yields down has aggravated the issue, creating an enormous additional burden companies could not have foreseen. The consequence is that many companies have not had money to invest in new factories and productivity improvements. Analysts in search of answers as to why investment and productivity gains have been so low in recent years should look at the struggle of many companies to deal with legacy liabilities. That is a key underlying issue.

Negative feedback

Misfiring monetary policy creates its own feedback loop. Investors looking at abnormally low interest rates assume they reflect market expectations, as they have historically. For instance, investors assume the UK’s ten-year interest rate embeds such low market expectations of growth and inflation that investors are satisfied with receiving 0.5 per cent nominal interest rates over the next ten years.1 However, most buyers of long-dated bonds are forced to do so because of huge historic liabilities and regulation.

Japan’s experience in recent decades offers a salutary reminder that keeping rates down for long periods is not a cure-all for deflation

When central banks buy available bonds they drive a negative spiral that forces liability-hedgers to buy, thereby creating a second-round effect. Economic commentators could interpret the data as a sign of low business confidence and inflation expectations, which might weigh on their outlook and make companies more nervous about investing. Such pessimism could then feed back to commentators, and so on. By not allowing a steeper yield curve, central banks are at serious risk of creating a deflationary cycle. Japan’s experience in recent decades offers a salutary reminder that keeping rates down for long periods is not a cure-all for deflation.

What next for investors?

Unfortunately, given how addicted financial markets, businesses and individuals have become to low interest rates, central banks may have a tough time raising them. If that proves to be the case, individual savers will need to think about what to do next. In fact, people saving for their retirement through a typical balanced fund (60 per cent equities and 40 per cent bonds) have been the beneficiaries of a unique multi-decade experience where both bonds and equities delivered attractive returns – the last leg of which has been fuelled by monetary easing.

In time, they may come to realise how lucky they have been and recognise future returns will likely be lower and the asset mix no longer appropriate. Or put another way, it is better to be in a world where interest rates are travelling to zero than in one where interest rates stay at zero for a long time.

For investors looking for income in retirement, equity markets may still be a viable option

For investors looking for income in retirement, equity markets may still be a viable option – particularly given that fixed income markets have gone ‘post-income’, with some estimates suggesting over a quarter of the market now offers negative yields. But before equities can become a core part of future retirees’ solution, investment managers will need to prove they are able to ‘defang’ the equity risk as any risk of capital depreciation becomes exacerbated in later life. Income is also available for investors willing to tie up their money for longer in real assets such as property and infrastructure, but they must become comfortable with less liquidity.

Finding a cure for the cure

The situation will likely remain more difficult for companies struggling with massive liabilities, which will only see their burdens begin to ease when long-term interest rates begin to normalise. Until then, they would benefit from more supportive fiscal policy.

The world is crying out for fiscal investment and state involvement can be transformative for growth

Indeed, if interest rates stay at this level for the foreseeable future, governments should capitalise on the opportunity to invest in projects that will benefit their economy and society, by borrowing at next-to-nothing.

The world is crying out for fiscal investment and state involvement can be transformative for growth, not to mention the transition to a low-carbon economy. The investments needed are huge, but we are not going to get many chances to make them at such low borrowing costs. So why not do it now?

A version of this article originally appeared in The Times.

References

  1. 'UK Gilt 10-year yield', Bloomberg, 4 October 2019

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL) as at October 2019. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.

In the UK & Europe this material has been prepared and issued by AIGSL, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. In France, Aviva Investors France is a portfolio management company approved by the French Authority “Autorité des Marchés Financiers”, under n° GP 97-114, a limited liability company with Board of Directors and Supervisory Board, having a share capital of 17 793 700 euros, whose registered office is located at 14 rue Roquépine, 75008 Paris and registered in the Paris Company Register under n° 335 133 229. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH, authorised by FINMA as a distributor of collective investment schemes.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material.  AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583. In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.