With the market currently pricing a continuation of cheap money forever, it might be helpful to see what forever used to look like. The BOE have just produced a nice Working Paper and accompanying blog post, which usefully show us that that lower interest rates have been a seven centuries old trend:
Our current levels of low interest rates are thus just some kind of Marxist style historical inevitability then? Possibly, but the present cycle of ever-lower rates is relatively unusual over this historical period. The authors point to just nine examples of “real rate depressions” and the current one is the second longest:
Albert Edwards’ Ice Age thesis is alive and well. The deregulation and globalisation of finance appears to have tempted central bankers, whether subconsciously or otherwise, to drive rates lower and lower as crises popped up. And how does history teach us that these cycles end?
‘Most of the eight previous cyclical “real rate depressions” were eventually disrupted by geopolitical events or catastrophes, with several – such as the Black Death, the Thirty Years War, or World War Two – combining both demographic, and geopolitical inflections. Most cyclical real rate depressions equally coincided with inflation outperformances.’
So either politics or inflation are to blame. Or sometimes, there’s not much inflation, it’s merely the bursting of a financial bubble. The authors parallel our current period with the late 19th Century:
‘Following years of a global railroad investment frenzy, and global overcapacity indicators inflecting in the mid-1860s, the infamous “Panic of 1873” heralded the advent of two decades of low productivity growth, deflationary price dynamics, and a rise in global populism and protectionism.’
This was brought to an end by a boost to labour productivity following the discovery of Gold at the Klondike, and the election of a pro-business protectionist Republican President McKinley, driving wages back up. So politics and inflation eventually intervened, but there was no deliberate fiscal or monetary stimulus, unlike, say after a War.
In the Working Paper, which should be required reading for anyone who’s only worked in finance post 2008, the BOE authors explain clearly and concisely what happened in more recent history when rates suddenly turned. They reflect on the 1960s US Tsy reversal, the 1994 ‘Bond massacre’ and the 2003 JGB VaR shock. They flag up:
- The 1994 mayhem wasn’t caused by Fed hikes or inflation per se, but rather Greenspan’s failure to talk up a ‘steepening bias’. His communication shifted after the Fed were forced to be more transparent in their communication and publish Minutes of their meetings, along with the Democrats’ drive to ‘restrain central bank independence via its appointment procedures‘
- The JGB VaR shock was ultimately stabilised when its architects reversed course, following central bank Governor Fukui’s reassurance over the conditions of QE: ‘as the prospects for curve steepening improved, the major banks were once again quick to increase risk tolerance and increase (short-term) JGB exposure‘
- The 1960s saw inflation bounce back with only a mild fiscal stimulus from LBJ, given the tight labour market
What are we to learn from these case studies?
- ‘The lessons for the Federal Reserve… would be to pay greater attention to changes in official language and transparency, as well as the uncertainty generated by political interference‘.
- ‘neither hard data nor the BoJ did directly trigger the sell-off in JGBs, which is far more consistent in its timing with financial instability after the Resona bailout, and doubts over the banks’ business model… But if not in intent, in effect the monetary authorities staved off worse turmoil by finding language that steepened bond curves‘
- Inflation can come back suddenly ‘even given the fact that the business cycle was, at 69 months after the last NBER recession, already at mature stages, and the Federal Reserve Board under William McChesney Martin had initiated its hiking cycle by July 1963’
In other words:
- central banks must be clear, but can’t keep curves flat forever
- inflation is an unpredictable beast
- politics creates instability
Seven centuries have taught us that severe interest rate depressions are rare and that when they reverse, they reverse quickly:
Right now we are living through one of these periods. It will not last forever. But why should it stop now? Well, ask yourself if the pieces are in place for a central bank miscommunication; political interference; or a return to inflation. Too much analysis of the end of the bond bubble focuses on the return to inflation, perhaps unsurprisingly in our inflation-targeting age. Market players, burnt by the Taper Tantrum, also obsess over central bank communication. A lack of liquidity might well be the kindling for the next shock, but it won’t be the spark for the fire. That leaves us with politics. Currently misunderstood and ignored because it can’t be priced. 700 years of history suggests that this is the strongest culprit for a bond market bust.