Why interest rates aren’t going back to normal

Interest rates near zero are a form of financial repression and an obvious calumny for fixed-income retirees. However, in my view interest rates will not only remain low for a while, but they could also stay below 2% to 3% until somewhere in the middle of this century. Indeed, I would question whether rates might ever go back to “normal”.

That’s certainly what many banking analysts I’ve talked to think as well. They reckon that low rates will be a near permanent feature of the future economic environment. That’s not to say that interest rates will not rise at all, especially in the US. My guess is that if the Federal Reserve swings decisively into action we could see as many as six to seven 25-basis-point moves over the next 18 months. That could take US rates through the 2% barrier, maybe to hit 2.5%. However, my guess is that rates would then come crashing back to 0% almost as quickly.

Why? I believe that there will be three headwinds against rising rates, all of which will combine to produce a situation with tricky investment implications. Headwind one is the sheer scale of indebtedness. Global debt has grown by $57trn since 2007 and no major economy has decreased its debt-to-GDP ratio, according to consultants McKinsey. Put in the very broadest terms, this mountain of debt globally would be just too big to service if interest rates approached 5%.

What’s more, if President-elect Donald Trump is to embark on his alleged fiscal pump-priming, he’s going to need to borrow a vast additional amount of money to add to the mountain of debt already issued by the US Treasury. A massive hike in rates against this backdrop would be hugely deflationary, entirely offsetting any benefits from Trump’s increased public spending and probably catapulting us back into a new Great Depression.  So there is huge pressure to keep rates low to prevent this from happening.

Second, normal interest rates might be possible if global economic growth rates were normal. But they aren’t. Trump was propelled into power by a sense that US growth isn’t what it used to be. Many economists argue that much of this lower growth can be accounted for by the demographic changes under way in the US, the UK and other countries. As our societies get older, we save more, spend less and drag down our headline GDP growth rates (although per capita rates might not be as grim). That feeds through into a deflationary cycle, where price rises don’t stick. This will in turn help drag down long-term interest-rate expectations.

Perhaps the most obvious headwind is simply tactics and timing. If we believe that a normal rate is approaching 5%, we wouldn’t start from where we are, which is close to zero. We’ve already had a few taper tantrums over a 0.25% rise, so imagine what would happen if we had six or seven putative 0.50% rate hikes. And even if we achieved this, rates would still only be above 3%. It is therefore very difficult to see how rates return to 5% without causing too much disruption to markets – something central bankers are determined to avoid.

Hence my money is on lower rates for a very long time, probably coupled with more radical measures in some future crisis. Against this backdrop, if you’re after income, you have no choice other than to chase yield wherever you can find it. For example, if corporate bonds issued by firms with strong balance sheets temporarily yield more than 4%, snap them up. And keep an eye out for  interesting new asset-backed funds, such as the Civitas Social Housing investment trust I wrote about last week.