Burgess COMMENTARY

Peter Burgess

Konstantin Fominykh Konstantin Fominykh Founder, CEO at TenViz Following Why Interest Rates Would Stay Low, No Matter What the Fed Says or Does Nov 12, 2015

This is a Part 1, starting a series of articles: Why Interest Rates Would Stay Low No Matter What the Fed Says or Does.

Part 1: Why does Demography drive interest rates? Because it should

Let’s stir the pot: we forecast that the US Treasury 10 Year Yields would oscillate around 2.2% ±50 bps for many years to come. Bold, yeah?

Aging Demographics is the key driver behind low interest rates. The idea is not really new and is related to Modigliani’s Life cycle hypothesis. In the following series of articles we will examine and quantify from many angles why and by how much the 3 highly inter-related forces: Demographics, Deficit and Debt (government) would keep interest rates low for a long as an eye can see. Robert Arnott calls them “3-D Hurricane”. Or as Bill Dudley, the President of NY Fed noted:

“Demographic factors have played a role in restraining the recovery. As the population ages, this has two consequences. First, the spending decisions of the older age cohorts are less likely to be easily stimulated by monetary policy… because such age groups spend less of their incomes on consumer durables and housing. Second, as … the number of retiree’s climbs, the costs associated with Social Security, government pensions, and healthcare retirement benefits increase. This creates budgetary pressure and leads to a choice of raising revenue to fund these costs, cutting other government programs, or cutting benefits.”

But let’s check the facts first. In all consumer-driven economies the Demand for capital is driven by age-determined needs to finance durables: primarily, houses and cars. As the Figure 1 illustrates, mortgages dominate consumer debt. Obviously, most people buy their first home when they are young. In the US, consumers apply for a mortgage to finance their first house around the age of 28-32 (see the Figure 2):

Consumers also tend to apply for a car loan when they are young. Therefore, it is very natural to see that as Americans age their demand for capital wanes. Consumers do indeed grow their Debt levels mostly around the ages of 18-39, as the Figure 3 shows:

Conversely, the capital to younger generations (spenders) is provided by older generations (savers), who seek yields on their investments. See the Figure 4 above. When we have fewer young people, the demand for capital declines, while older people try to save and offer their savings for reinvestment (high yielding bonds, please!). And don’t forget, that once you get your mortgage, you immediately become a saver by starting to pay a portion of the principal on a monthly basis. Funnily, what we would call “old” or “older” here, is not that old at all! It is just that their consumption patterns mature as they shift more towards savings and more leisurely spending (we will discuss impact from retirees later).

In summary, Demography should determine demand for consumer Credit: ages 18-35 is the fastest period of growth for Consumer Credit, while consumers at Ages 40+ becomes recipients of Interest Income. The idea is that the aging demography indeed weakens demand/supply for credit. There is no way around it.

In the next Part 2 we will quantify via a simple regression why aging demographics foretells that Interest rates (US10Y) should stay around 2.2% several years out.

Stay tuned and please comment below!

https://www.linkedin.com/pulse/part-2-why-lower-interest-rates-lead-higher-debt-konstantin-fominykh

Part 2: Why lower interest rates lead to higher government debt

Nov 18, 2015

255 views14 Likes4 CommentsShare on LinkedInShare on FacebookShare on Twitter This is a Part 2 of a series of articles on: Why Interest Rates Would Stay Low No Matter What the Fed Says or Does. Read Part 1 here, please.

Most people would argue that higher level of government debt would lead to higher interest rates making an intuitive analogy to a consumer with poor credit scores who can only get a loan at some elevated rates. But interest rates spikes for sovereign debts happen only for relatively short periods of time typically in small economies experiencing a deep economic crisis (think European PIIGS from the recent crisis there). This is a cyclical phenomenon. We will elaborate on a circular trends in large, established economies where lower interest rates cause to higher debt levels.

The root of these developments is the same – aging demographics. The causality chain is roughly the following:

Aging demographics undermines demand for large ticket durables (houses and cars, see the previous Part 1), and produces an oversupply of people seeking reinvestment of their savings. This lowers demand/supply equilibrium for capital and predictably pushes interest rates lower. Remember, that in its most basic form, interest rate is nothing but the cost of capital, especially evident between generations. Aging demographics, also damages the growth in employment and ruins growth in labor productivity. Obviously, older people are predictably less agile at accepting new ways of doing things.

All of those intertwined effects result in decreased GDP growth and slower growth in government tax revenues. At the same time on the expense side, governments start facing escalating obligations to growing pools of retirees. Most of those obligations are age-related (retirement age or eligibility for different transfers or subsidies). A government that faces a double whammy of a contracting tax revenue base and increasing financial liabilities to retirees, would inevitably turn to debt markets to finance its obligations. Fortunately, by that time interest rates tend to be quite accommodating (by being very low) and it is easy to fund the growth in government debt. The following grossly simplified diagram illustrates why in established economies, aging demographics predictably leads to higher government debt (see the Figure 5):

The traditional logic that the government debt should be expressed as some sort of ratio to GDP goes out the window, as it should! Is this crazy? No, this is a highly rational and, probably, inevitable situation. Seriously, we make no judgements here whether a growing government debt is a bad thing or not. But practically speaking, there is no easy way around it. As we follow this logic further, we also observe a clear negative feedback loop: higher government debt leads to the elevated debt burden and that knocks the growth of the economy further down. Instead of investing in value-creating activities with long multiplier effects (infrastructure, education, etc.) a government is forced to pay pensions and healthcare obligations.

Lower interest rates do indeed allow to borrow more. The best analogy is a consumer shopping for a car based on her ability to meet monthly payment. Remember going to a car dealership and having an ultimate discussion centered around the amount of a monthly payment? That amount does include both the interest rate and the negotiated price of a car.

The key conclusion here is that in stable, mature economies, there is an Inverse relationship between the level of government debt and the level of interest rates. In the US history, the long term trends are clear - the level government debt moves in inverse relationship to interest rates. See the Figure 6.

Even with expected spikes in debt caused by major wars (WWI and WWII), it is very clear that higher (and ascending) interest rates (see the periods of 1900-1920 and 1955-1980) always acted as a check on government finances, reigning back government’s borrowing. Conversely, low and dropping interest rates allowed higher borrowings in 1925-1940 and in 1980-2015. We strongly believe that the trend onward is well grooved in! We can over-analyze and debate every economic cycle and one-off impacts including Great Depression, Oil Embargo, Wars on Terror, etc. but the dominant trend is still prevalent. Governments end up being literally hooked on low interest rates – we are talking about decades (as our Cover Picture illustrates).

In the subsequent parts we would demonstrate and quantify how in other major mature economies governments predictably use benign interest rates to fund their swelling obligations via issuing debt.

Comments, please!

https://www.linkedin.com/pulse/part-3-how-fed-would-react-coming-crisis-china-wish-could-fominykh

Part 3: How the Fed Would React to the Coming Crisis in China? Wish they Could Cut Rates NOW

Nov 23, 2015

This is a Part 3 of a series of articles on: Why Interest Rates Would Stay Low No Matter What the Fed Says or Does. Read Part 1 and Part 2, please.

The brewing dramatic slowdown in China should lead to a severe recession and almost inevitable crisis – we can only debate its scope and length. But this is how the US interest rates could be affected and how the Fed could react. Let’s relive the last Asian crisis of 1997 for some analogies.

During 1986 - 1996 the economy of Thailand grew north of 9% per year, the highest pace worldwide at the time. As the Thai central bank mismanaged the Thai baht, which was pegged to the basket of currencies, Thailand's economy came to an abrupt halt. There was massive layoffs in the Real Estate, Finance and Construction industries and many laborers had to return back to their villages and more than half of a million foreign visiting workers were dispatched home. The Thai stock market collapsed by 74%. Finance One, the largest Thai private financial institution in 1996, went belly up and was sarcastically ridiculed as “Finance to Zero”.

The story of South Korea in 1997 had similar twists of unbalanced expansion. The banking industry was burdened with non-performing loans as major Korean companies were financing aggressive growth. Some high profile businesses failed to return to profitability and, ultimately, accumulated debt caused high profile restructurings. Kia Motors needed emergency loans and Samsung Motors' venture was scrapped, and Daewoo Motors was sold to GM. KOSPI index was down 60-70%.

As crisis unfolded in Thailand and in Korea, US Interest rates (10YR) went down from 7.0% to 4.1% (predictable flight to quality and safety), despite the Fed’s inactivity (See the Figure 6). Eventually, the crisis dented many Emerging Markets including Russia, Brazil and Argentina. Then, the Fed started to react to the broadening crisis (and LTCM was one of indirect casualties that catalyzed that), effectively lagging equity indices there. Check how systematically Fed FFR moves lag market-driven changes to the 10YR yield, all driven by the agitated market.

Developments leading to the 1997 Crisis in Thailand and Korea (and across South-East Asia back then) have many similarities to modern China, if not in every detail but definitely in the spirit of 3 OVER’s (Over-built, Over-growth, Over-leverage). Long breakneck expansions never come without a steep price to bear. But there are 2 key disturbing difference between the Asian crisis of 1997 and the coming crisis in China:

1.Back in 1997 the size of the economy of Thailand was ~2% of the US GDP, but now the size of the Chinese economy is >65% of the US economy

2.Back in 1997 the Fed had ability to cut rates and now it doesn’t

So, if in 1997 a crisis of a handful of relatively small economies in Asia caused a meaningful bid to US treasuries and led to series of rate cuts by the FED, then what should we expect when the economy of China slides into a recession? I really wish the FED had room to cut rates preventatively… preferably, now.