The unwelcome consequences of lower for longer

3 minute read

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 – 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.

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 – 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.

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.