Ready For An Era Of Ultralow Interest Rates?
Careful What You Wish For

Jed Graham

Stock market investors are pulling for more Fed rate cuts, because what's not to like? They make price-earnings multiples more attractive, debt easier to carry, and grease the wheels for stock buybacks. They might even knock the dollar down a peg, boosting profits earned in foreign currencies.

Yet now that odds are surging for another Fed rate cut later this month, don't mistake it for good news. This time, lower interest rates may not be just a detour on a path to higher Treasury yields. They might be a destination: a new era of extremely low interest rates.

Japan, Germany and much of Europe already are stuck with negative yields. That means investors are willing to pay governments, and in some cases, corporations, to borrow their money. While it's not yet clear when the next leg down for long-term U.S. interest rates will begin, the risk is high that it will be long-lived and bring dramatic upheaval to finance and government.

Interest rates have been trending lower for nearly 40 years, a big factor supporting economic growth and fueling higher stock market valuations. Even-lower interest rates might be relatively benign for industry titans such as Apple (AAPL), along with homebuilders like Lennar (LEN) and high-dividend companies such as REITs and utilities that are seen as bond substitutes.

But ultralow borrowing costs offer a virtual blank check for government spending. That could spell the effective end of Fed independence. The reason? Policymakers would have little scope for Fed rate hikes without sending government debt servicing costs through the roof. Ultralow yields on safe bonds raise the specter of pension fund crises on steroids and may push institutional investors' quest for higher yields to extremes.

"It's a much bigger risk for everyone if rates go down, rather than up," Michael Crook, head of Americas investment strategy at UBS Wealth Management, told IBD.

Yet there are powerful global forces behind the decadeslong trend to lower and lower interest rates, such as aging demographics. "It's not clear now what would reverse that," he said.

U.S. Interest Rates Hit Ceiling In 2018

Just a year ago, the 10-year Treasury yield was testing 3.25%, the highest since 2011. The jobless rate had sunk close to a 50-year low. Federal spending stimulus and a huge, deficit-financed tax cut were propelling the economy to the best annual growth since 2005. Many, including, Jeffrey Gundlach, Wall Street's so-called bond king, predicted a 4% 10-year Treasury yield. Instead, the 10-year Treasury yield collapsed, sinking as low as 1.45% in September, close to a record low. Treasury yields rebounded to 1.9% on Sept. 13 but have fallen back to 1.51% as of Oct. 4.

And yet, America's ultralow interest rates stand out for being above zero. Negative interest rates have increasingly taken hold in the rest of the developed world. In August, negative yielding debt rose as high as $17 trillion. Bank of America Merrill Lynch found that 95% of investment grade credit with positive yields came from the U.S.

Investors are plowing money into "really low returning assets rather than in productive enterprises," suggesting that ultralow rates are not so stimulative, Crook said.

Negative Interest Rates A Dead End?

Low rates for longer — or their extreme version of negative interest rates — aim to send a signal that borrowing costs will remain cheap long enough to put the economy on firm footing and get inflation percolating. That's supposed to encourage economic risk-taking and consumption. Yet it can also induce more conservative behavior.

"After Japan introduced a negative policy interest rate in 2016, market expectations for inflation over the medium term fell immediately," San Francisco Fed researchers Jens H.E. Christensen and Mark M. Spiegel wrote in August.

"The overall impact is that lower yields can induce households, or companies that act as plan sponsors, to save even more for the future," wrote JPMorgan strategist Nikolaos Panigirtzoglou. "In our conversations with clients, the experiments of central banks with negative rates are viewed more as a policy mistake rather than stimulus."

Extremely Low Interest Rates Breed Market Concentration And Corporate Zombies

In early September, Apple, Deere (DE) and Disney (DIS) took advantage of the drop in rates to issue 30-year debt with a sub-3% interest rate. In late August, Germany's Siemens (SIEGY) floated 2- and 5-year debt with negative yields.

One might think low corporate borrowing costs would fuel economic growth, but not necessarily.

New research from professors Ernest Liu and Atif Mian of Princeton and Amir Sufi of the University of Chicago finds that ultralow interest rates may be contractionary because they lead to increased market concentration. That would tend to depress productivity growth.

"Because industry leaders respond more strongly to a decline in the interest rate, followers become discouraged and stop investing as leaders get too far ahead," their research suggests. Easy money facilitates acquisitions to eliminate an emerging competitor, for example. The effect may be magnified by rising stock market price-earnings multiples that come with low rates.

Other research indicates that low interest rates have helped spawn the growth of so-called zombie firms, which lack the profits to fully service debt. Bank of International Settlements researchers found that zombies accounted for 12% of advanced economy firms in 2016, up from 2% in the late 1980s. One key reason: Firms were more likely to stay zombies, rather than recover profitability or exit via bankruptcy.

Homebuilders and related stocks like Lennar and D.R. Horton (DHI) are faring well, as low mortgage rates spur demand. REITs and utilities pay dividends that look attractive in a world of low or negative interest rates.

While there may be relative stock market winners from ultralow rates, Japan's stock market over the past three decades suggests an overall negative trend.

Aging Population Slows Growth, Lowers Interest Rates

Fed researchers estimated in 2016 that aging demographics had cut 1.25 percentage points from trend GDP growth and the neutral real interest rate in the U.S. since 1980. Most of that decline came since the early 2000s.

The global impact may be greater. Japan's working-age population has been falling for eight years. More recently, China, Germany and South Korea have seen declines.

The Fed researchers noted an "abundance of capital relative to labor" as baby boomers retire. That excess saving helped depress returns on capital and explain "puzzlingly low rates of capital investment."

The dollar's dominance as the world's reserve currency also contributes to higher savings, depressing growth and interest rates. Having lived through the Asian flu and other crises, emerging market economies have built up an excess of dollar-based safe assets as reserves to guard against future market panics.

"These dynamics are now increasing the risks of a global liquidity trap," Bank of England Gov. Mark Carney told the Fed's August Jackson Hole monetary policy symposium.

Fed Rate Hikes Sent Dollar Soaring

President Donald Trump's China trade war has chilled global growth and dragged down interest rates. But the Fed and the dollar also have played leading roles. The June 2018 Fed rate hike and forecasts for five more rate hikes over the next 18 months sent the dollar surging. That signaled the end for the short burst of synchronized global growth.

The strong dollar, fueled by Fed rate hikes, "caused major breakage in many EM (emerging market) economies," wrote Pimco's Joachim Fels.

With two-thirds of EM debt denominated in dollars, debt costs soared in local currency terms. In the case of Brazil's then-No. 4 airline, Avianca Brasil, the higher cost of dollar-based airplane leases helped push it toward bankruptcy.

U.S. dollar credit to non-bank borrowers outside the U.S. totaled $11.8 trillion as of March, according to the Bank of International Settlements.

The strong dollar spillovers didn't take long to produce "significant spillbacks" for the U.S. economy, Fels wrote. Exports slowed. U.S. multinationals reined in earnings expectations. Mounting pressure on U.S. equities came to a head last December after the final Fed rate hike, despite a China trade thaw. Since then, it's been almost all downhill for Treasury yields.

Why Low Interest Rates Yield Still-Lower Rates

Fed rate hikes are a problem, but rate cuts may not be a solution. One of the biggest macro forces lowering the interest-rate ceiling may be low rates themselves.

"By historic standards a 2.50% Fed Funds rate is not tight," wrote Simon Laing, head of U.S. equities at Invesco. "What can we infer about the structural health of the US economy, if rates of 2.50% are enough to cause markets to panic about growth? This is one of the unintended consequences of running zero interest rate policy for such a long time."

David Levy of Jerome Levy Forecasting connects the long downtrend in interest rates to "the swelling of both assets and debt relative to income."

That combination "made rising interest rates destabilizing at progressively lower ceilings and made progressively lower interest rates necessary to end crises and spark recoveries," Levy wrote in a September report, Bubble or Nothing.

Households deleveraged in the wake of the Great Financial Crisis. Yet corporate debt is near its 2009 peak relative to gross value added, Levy notes. Household assets vs. GDP hit a record high in Q3 of 2018. He adds, "the rest of the world now appears more dangerously out of financial balance than the U.S."

Does Fed Need New Toolkit Beyond Rate Cuts, QE?

Are U.S. interest rates and Treasury yields about to sink into the same negative rate swamp that has engulfed Japan's economy and spread to Europe? Maybe not. China trade tensions have abated, and talks resume next week. While factory data have slumped and job growth cooled, the American consumer still looks solid. Global central banks are easing. Germany might enact fiscal stimulus. Yet Fed policymakers have long feared they'll enter the next recession with little ammunition. After the collapse in interest rates over the past year, that's looking as likely as ever.

In past cycles, the Fed had room to cut its benchmark rate by about 500 basis points. Yet now, after just a half point in easing, the fed funds rate is already down to 1.75%-2%, with expectations of another quarter-point cut this month. Even quantitative easing may struggle to stimulate growth when long-term Treasury yields don't have much further to fall.

"Monetary policy has sort of exhausted its usefulness," Ed Yardeni, chief investment strategist at Yardeni Research, told IBD.

Fed policymakers won't go that far. But they're "asking whether we should expand our toolkit," Fed chief Jerome Powell said at Jackson Hole.

The question is an urgent one, Powell acknowledged. "We face heightened risks of lengthy, difficult-to-escape periods in which our policy interest rate is pinned near zero."

No Way Out?

There are no easy answers. Japan has been stuck in a slow-growth, ultralow or negative interest-rate environment for decades. It's tried massive fiscal stimulus and huge quantitative easing. Nothing did the trick, even in periods of solid growth in China, the U.S. and much of the world. Now, with rates turning negative in Germany and elsewhere, the world seems to be slouching toward Japanification. How will America get out of an ultralow interest rate trap with much of the developed world in similar or even-worse straits?

The European Central Bank and the Federal Reserve are set to begin modest balance sheet expansions. Those don't appear to be game-changers. An actual China trade deal would take an immense weight off the global economy, serving as a de facto global synchronized stimulus. But that may not be realistic, at least in the near term.

Time For Fiscal Stimulus?

Ray Dalio, founder of the world's largest hedge fund, Bridgewater Associates, thinks the Federal Reserve needs new tools to put money in the hands of spenders, rather than investors.

"QE and interest rate cuts help the top earners more than the bottom (because they help drive up asset prices, helping those who already own a lot of assets)," Dalio wrote. "And those levers don't target the money to the things that would be good investments like education, infrastructure, and R&D."

That would require "fiscal and monetary policy coordination" to an extent that "most of us haven't seen in our lifetimes."

Modern Monetary Theory

Dalio's vision overlaps to a large degree with Modern Monetary Theory, the strain of left-wing thinking that sees bigger deficits as better — up to the point that inflation takes off. But he does warn that giving Congress and the White House the power to create and allocate money is risky.

In Yardeni's view, a version of Modern Monetary Theory is already being tested. "It's not really a theory. It's what we've been doing for 10 years," he said, alluding to central bank bond buying that facilitated more government spending.

The annual federal budget deficit is on a path toward roughly $2 trillion within a decade, or more than 6% of GDP. That reflects Congressional Budget Office projections of current policy, which assume that tax cuts won't expire.

If the Fed anchors interest rates near zero, and debt servicing costs plummet via record-low Treasury yields, the federal government could spend with abandon. Democrats surely want to, on universal health care, student loan forgiveness and more. The Federal Reserve might then be reduced to enabling big-spending politicians. With noninterest outlays soaring, Fed rate hikes would be a non-starter to prevent a debt servicing crisis.

Bailouts And A New Economic World

Yet ultralow interest rates could mean a big bailout of public pension funds. The top 100 state and local pensions already face a $1.1 trillion funding gap based on overly optimistic 7.25% return assumptions. Fed data put the unfunded liability for U.S. pensions at $6.2 trillion. That includes federal employees, but not Social Security.

It's hard to imagine how all this would play out. Trying to manage an economy through cyclical highs and lows with always-ultralow rates would mean easing and tightening via fiscal policy. Modern Monetary Theory advocates have suggested that a guaranteed jobs program could modulate growth via bigger or smaller wage hikes. One thing seems clear: Everything investors have learned about not fighting the Fed and interest-rate cycles would go out the window.

Please follow Jed Graham on Twitter at @IBD_JGraham for insight on economic policy and financial markets.

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