On June 28, the Bank for International Settlements, an intergovernmental organization of central banks, in its annual report warned central banks against keeping interest rates low for too long.
BIS, a kind of central bank for central banks, acknowledged reducing rates to record lows “was necessary to prevent the complete collapse of the financial system.” And it is not recommending hikes now. But it is concerned that the latest crisis in Europe may delay for too long a “necessary” return to normal monetary policy.
In ordinary times, monetary policy has two basic goals: to promote maximum sustainable output and employment and to promote stable prices.
The BIS said that, although central banks might feel compelled to preserve easy monetary policies in times of weak growth and high unemployment, this alone can not solve underlying solvency or deeper structural problems.
Despite the BIS warning, China, the Eurozone and Britain on July 5 loosened monetary policy, signaling their growing alarm about the world economy.
Because of the global economic slowdown and the European debt crisis, the demand from savers for safe assets has overwhelmed the supply of new bonds. Almost $1 trillion has gone into bond funds since the start of 2009. With interest rates at historically low levels in America, Germany and Great Britain, bond investors cannot expect further capital gains if interest rates fall further.
The BIS warned that artificially low rates induce banks to leverage their balance sheets and hold on to bad assets. Banks are tempted to spend the money on financial speculation rather than invest it in capital improvements. The recent JPMorgan trading fiasco that could cost the bank $9 billion reflects such speculation.
The BIS worries that the low interest rate policy causes asset bubbles and inflating commodity prices. When central banks eventually need to stem inflationary pressures by pushing up short-term interest rates, the subsequent higher borrowing costs will exacerbate the financial burdens for already cash-strapped governments.
Foreigners, primarily central banks, now own more than $5 trillion of U.S. debt. They are either just looking for a liquid home for their assets or they are buying the bonds as a way of managing their country’s exchange rate against the dollar. The United States is heavily indebted to oil-rich nations and to non-democratic countries like China. Down the road, these countries might convert their bond holdings to owning a large chunk of the United States.
History suggests that investing at the current low level of Treasury yields is a very poor decision. Investors who bought Treasury bonds at a 2 percent yield in 1945 earned a negative real annual return of 2.3 percent over the following 35 years, according to the Barclays Equity Gilt Study.
For almost my entire Wall Street career, I was an executive in the fixed-income departments of major firms. My experience makes me wary of the current environment of ridiculously low interest rates.
Real rates of return were negative during the 1970s — the beginning of my career — because of high inflation. Today, real rates of return are negative for a different reason. Bond investors today accept low absolute returns because they are unwilling to put money into equities or other risky investments. Not even the Great Depression pushed bond yields down this far.
The Fed has maintained interest rates at or near zero for more than four years, although the financial system has been relatively stable since 2009. Sooner or later this bond bubble will burst. Easy money policies of central banks, combined with the rising amount of debt, will eventually spark a rapid acceleration in inflation and a spike in bond yields.
I agree with Warren Buffett, who said that investors should avoid bonds.
Katy, bar the door! There is trouble ahead.
Originally published in the Sarasota Herald-Tribune
