LOW RATES MAKE THE WORLD A RISKIER PLACE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

August 17, 2011 2:18 pm

Low rates make the world a riskier place

By Peter R. Fisher

Following the downgrade of the US sovereign credit rating, investors continued to do what they had been doing: selling riskier assets, such as equities, and buying safer ones, such as Treasuries. The downgrade provided no new facts but underscored fears that the world is a risky place.


The US is now adapting to a growth rate that is much lower and more volatile than it is accustomed to. Working off the accumulated debt of the past two decades weighs on wealth, as assets are written down, and diverts a larger share of lower incomes to debt repayment, slowing economic growth for years to come. The reluctance of businesses and households to borrow, and of bankers to lend, makes growth more volatile because, rather than borrow to smooth the path of investment and consumption, when income declines, investment and consumption fall too.


American businesses and households are now net savers. If government cuts spending too quickly, and becomes a saver year after year, the US will be forced into a terrible recession unless it can promptly run a surplus with the rest of the world. The rest of the world is not likely to let this happen.


The US should act now to cut dramatically its future spending while not cutting spending in the next two years while the economy needs support. The risk is that the politicians do just the opposite.


In Europe, political leaders appear unable to recognise that the transmission mechanism of contagion of the sovereign debt crisis is across bank balance sheets. As some countries struggle to pay their debts, or acknowledge that they cannot, the assets of banks decline in value which, in turn, forces banks to reduce risk by selling other assets, most likely other government bonds. Bond buying by the European Central Bank is a stop gap measure and one that makes the ECB the de facto price setter for government bonds. Until Europe can acknowledge that many of the sovereign debts cannot be repaid in full and assure the soundness of the banks when that happens, the crisis will continue.


China faces the awkward task of switching from investment to consumption as the engine of growth. Even if well managed, this will be difficult. Almost half of Chinese economic activity is now investment. This means that when investment stops increasing year after year, the rate of growth of the Chinese economy will be cut in half. It is highly unlikely that consumption can grow quickly enough to fill this hole. When this happens, the world economy will feel it both directly and through the likely decline in the value of the Chinese currency.


On top of this murky outlook, we also face elections in the US, France, and Germany, a change in the leadership in China and continued uncertainty about political leadership in Japan. With this many uncertainties, it should surprise no one that risk premiums are rising, yields and price-earning ratios are falling and that volatility has been extraordinarily high. Nor should it have surprised so many that demand for US Treasury securities rose and their yields fell. Maybe investors simply disagreed with S&P and viewed US Treasury securities as still being the asset with the lowest credit risk. More likely, the liquidity and price transparency of the Treasury market vastly outweighed the marginal increase in the credit premium the downgrade implied.


While most investors were digesting S&P’s action, the Federal Reserve announcement stating its willingness to hold rates close to zero for the next two years powerfully demonstrated that the term-structure of interest rates is principally determined by the expected path of monetary policy – pulling the two-year note’s yield below 20 basis points.


If investors now shun Treasuries it will not be because they are too risky but because they are not risky enough. While some investors will still seek the relative safety and liquidity of government debt, others will begin to migrate out of the yield curve, to pick up higher returns for longer maturities and into the bonds of stronger corporate and municipal issuers. Eventually, low returns in government bonds will drive some investors into equities and high-yield credit.


But investors’ quest for returns in a low-growth and uncertain world will not ensure a good outcome for the world economy. The rally in equity markets and confidence that took place in late 2010, stimulated by the Fed’s second wave of quantitative easing gave way to the weakening growth and uncertain outlook in the first half of 2011.


Policymakers need to come to grips with the uncertain state of the world and work together to reduce uncertainties rather than add to them. If they do not, they are likely to have both more volatility and low rates and learn – what the Japanese have already learnt – that low interest rates are not always the best interest rates.
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Peter R. Fisher is a senior managing director and the head of fixed income at BlackRock
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Copyright The Financial Times Limited 2011.