14 Nov 2019
On 9 November, Prof. Brian Cox who is a professor of particle physics and a TV and radio presenter responded to the news that credit rating Moody’s downgraded the outlook for the UK’s debt with this Tweet:
“Neither Labour nor the Conservatives will be able to borrow all the money they are pledging if international investors take fright.”
Pausing only to note that anyone who relied on Moody’s credit ratings probably got wiped out years ago, Prof. Cox’s view does not seem outrageously controversial to me. Yet he was buried by a landslide of comments such as:
“Don’t you just love it when experts step out of their areas of expertise and talk bollocks.”
In essence the message is that if Brian Cox thinks that interest rates might rise, then he must be an economic dumbo. But the important point is not whether the professor is a financial simpleton or not but that the crowd is so emphatically behind a view that would quite recently have been unthinkable. Groupthink now knows that interest rates will never rise and that governments can borrow whatever they like. Happy days.
And talking of financial simpletons, Donald Trump keeps criticising the Federal Reserve because other countries have negative interest rates on their government debt.
“Give me some of that. Give me some of that money. I want some of that money. Our Federal Reserve doesn’t let us do it.”
Source: Speech to the Economic Club of New York 12 November 2019
The remarkable fact is that Brian Cox is regarded as the one who “doesn’t get it” whereas President Trump thinks that he is espousing “the new normal”.
HOW DID WE GET HERE?
How did we get here and what happens if the consensus is as wrong as usual?
“I am concerned that this emerging anti-austerity consensus, driven as it is by the desire for perceived “fair” outcomes, could get messy. Meddling is in the air. An outbreak of doing the wrong thing cannot be far off.”
Source: CrowKnows “Prepare to turn left”
I wrote that exactly two years ago in the post “Prepare to turn left”. It is surely time to follow up because the steering wheel is about to be properly yanked.
A long-awaited general election is at last upon us and it is amazingly now time to quote myself again, from just three weeks ago
“As luck would have it, in today’s world of nearly free money, governments have an unprecedented opportunity to abandon fiscal responsibility and to borrow, borrow, borrow. You could say that the world’s central bankers have gifted politicians the chance, for a while at least, to say “the hell with taxpayers, we’ll raise the money ourselves”
Source: CrowKnows “No taxation without representation”
And so it has come to pass. The two main parties are competing with each other to offer manifestos with the juiciest spending promises. They have both noticed that many of the world’s governments can borrow for very little or in some cases less than nothing. They also appear to have come to the quite rational realisation that infrastructure investment should really be separated from the day to day government business of redistribution via taxing and spending.
If our government could really recognise that short term spending should be funded by taxation with the aim of breaking even, at worst, but that genuine long term investment in transport and communication infrastructure and perhaps education could legitimately be financed by borrowing, we would be living in a better and more honest world.
That this has even become a conversation is down to the lowest interest rates in history and for these we must mostly thank central banks and quantitative easing (QE). And the new attitude to borrowing displayed by both Conservatives and Labour suggests that low rates are accepted as the new normal.
LEFT HAND DOWN
There feels like an inevitability about what happens next.
Whatever the brand of the next government it seems highly likely that it will embark on a borrowing mission through the gilts market. The role of the Debt Management Office (DMO), which essentially manages the Treasury’s cash flow by redeeming (repaying) old gilts and issuing (selling) new ones is likely to become important to the execution of the government’s political agenda.
When QE began in the UK in 2009 it was in order to save the banks (improving liquidity in credit markets was how it was explained i.e. to prevent the forced sale of declining assets).
In 2011 QE was extended with a quiet repurposing – to inject money directly into the economy in order to stimulate economic growth.
In 2012 the goalposts were shifted again and the coupons paid on gilts owned by the Bank of England were handed over to the Treasury, thereby crystallizing substantial capital losses that will supposedly be need to be made good one day.
Now in 2019 the Bank of England owns around 24% of all gilts and, by buying and never selling, has helped to push yields down to what looks to many live a permanent low plateau. Indeed, mostly under the stewardship of the smooth and immaculately groomed Mark Carney, base rates have kept to a range of 0.25% to 0.75% since 2010.
REDBRIDGE REDS LEAD THE WAY
In financial year 2019/20 the DMO expects to redeem £99 billion of gilts and to issue £114 billion of new ones. Nobody seems to expect this to be a problem because demand for “safe” assets is strong and low yields are so normalised. Last week, a Labour-controlled London borough council (Redbridge) issued a bond at negative rates for the purposes of “capital expenditure”, a term that appears to cover buying family homes on the open market in order to meet demand for social housing (source: FT).
Who is buying this punitive paper? Whoever they are and whatever their motives this looks like one of those moments that historians will highlight with distinctly raised eyebrows. It has become the consensus view that interest rates will never rise and that buying negative yielding assets is the action of a financial sophisticate and beyond the understanding of ordinary mortals (like Professor Brian Cox).
But market rates are not set by the Bank of England, nor by the Treasury nor by Moody’s or Donald Trump. They are determined first by the current demand levels of borrowers and lenders and secondly by their mutual expectations of future inflation.
Wages have been rising faster than inflation for the last year. Given that wages are an important cost component of most goods and services it is reasonable to assume that prices will in turn edge up.
Now factor in a new government throwing money around. It would then be reasonable to assume that inflationary expectations would perk up as well.
Then, despite the new orthodoxy, it seems quite likely that the cost of borrowing will rise.
POLITICISING CENTRAL BANKERS
Politicians will complain. Central bankers are already under political pressure owing to the misguided belief that they can command interest rates to stay down. As we have seen, Donald Trump frequently berates Jerome Powell, the Fed chairman, for the fact that US interest rates are not negative. John McDonnell, currently UK Shadow Chancellor, has said that under a Labour government Mark Carney’s successor (due to be appointed in January 2020) ”must be in tune with our ideas”. And in pleasing harmony with President Trump, McDonnell has said that higher interest rates would be harmful to ordinary working families.
We may be on the verge of a major toy throwing outbreak. I am of course frequently wrong, but I do not think that bond market investors will be enthused by the sight of politicians dealing with rising interest rates by issuing threats. And what if the Treasury orders the Bank of England to keep buying new debt at low yields? That would effectively be the government buying its own paper. Then the whole world would be waiting for the bubble to burst while expectations of future inflation would start to ramp up.
“THE PEOPLE’S QE” – YOU HUM IT AND I’LL PLAY ALONG
Perhaps this is what the “people’s QE” looks like. Just like the previous incarnations of QE it would probably start to lift the prices of other assets again (and naturally increase the gap between the haves and the have-nots again). That would even include property if Redbridge council has much to do with it. Above all, it could be another boom time for those equities that escape the meddling of the next interventionist government. It may be one of those times when you just have to swallow your disapproval and go along for the ride. Just don’t forget to get off before the mad music stops.
For now, I am selling some of my gilts and buying Sainsburys which yields more than 5% and has just raised its dividend again. Maybe this is not so difficult.