Posts Tagged ‘interest rates’

Divergent view of Australian economy between domestic and foreign investors

Sunday, September 5th, 2010

Back in If the Australian economy ?booms? further, how is it setting the stage for a bigger bust later?, we wrote that

? as Australian-based investors, we are looking into increasing our allocations to investments that have greater exposure overseas

Increasingly, foreign investors seem to be concurring with our outlook. For example, as we wrote in What do overseas property investors see that Australian property investors don?t? foreign investors are getting more nervous about Australia?s housing market.

As this article in The Australian reported,

The Weekend Australian spoke to senior traders in New York, London and Hong Kong to gauge the appetite for investing in Australia. The overwhelming response was that global institutional investors are wary, despite the economy having emerged as one of the best performing in the world and avoiding a recession.

In fact, the debt market is predicting a small chance of interest rates cut next year. Currently, financial markets is pricing in a 40% of a rate cut of 0.25% by the first half of 2011. You can be sure that if the RBA ever cut rates, it will be in the context of bad news in the economy. As we wrote in What will happen if RBA cuts to zero?,

If Australia?s interest rates ever reach zero, it will happen in the context of a hard landing or even a depression.

Yet, on the other hand, forecasters in Australia are expecting that rates will continue to rise in 2011. For those of us residing in Australia, it is very clear from observing the mainstream media reports that the mood is pretty optimistic.

Since foreign investors have less of a stake in Australia than domestic investors, they will have the attitude of shooting first and asking questions later when they see trouble. That will translate to volatility in the AUD and stock market. That in itself can become a self-fulfilling prophecy.

Why interest rates policy can have opposite effect in China?

Thursday, April 22nd, 2010

In highly indebted countries such as ours, we associate lower interest rates with higher consumer expenditure and higher interest rates with lower consumer spending. The reason is simple. Since it is the norm for people to be indebted, lower interest rates implies lower debt servicing obligations, which implies greater borrowing capacity for spending.

Indeed, this was what happened in Australia when the Reserve Bank cut interest rates in 2008 to pre-empt any potential fallout from the GFC. The whole point of the interest rate cut was to help families repay their debt faster, which many did. But when the government dangled the higher First Home Owners? Grant (FHOG), many young people took this opportunity to borrow more. Lower interest rates certainly made it easier for these people to do so (which flowed on to the rest of the economy as increased consumer spending).

In countries like China, where the savings mentality is highly ingrained, lower interest rates have the opposite effect. To understand why, consider a typical Mr Wang who is saving for his son?s university education in say, 20 years time. Also, Mr Wang already has a substantial cash balance at the bank. When interest rates go up, Mr Wang will be earning greater returns on his cash at bank. With that, he can put aside less of his wages for savings, which implies that his spending can increase. When interest rates go down,  his returns on cash at bank reduces. Mr Wang will then feel that he needs to put aside more of his wages for savings, which implies that his spending have to decrease.

That explains why the Chinese consumers (especially the older generations) are so reluctant to spend. In fact, higher price inflation pushed many of the older folks to spend less in order to counter higher prices.

Remember, this is just our theory- that due to cultural differences, the demand for money in China is much higher than in Western countries (see Demand for money, inflation/deflation & its implication).

How is the Fed going to keep the lid on inflation? Part 2- Paying interest on bank reserves

Sunday, February 14th, 2010

In our previous article0 (How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate), we discussed about how the Fed is considering using the interest rates on reserves (instead of the Fed Fund Rate) as the benchmark rate. Some observers may ask this question: with so much excess bank reserves in the financial system, how is the Fed going to drain them out of the system in order to contain price inflation?

As it turns out, the Fed has one trick up its sleeves. The jury is still out on whether this trick will work or not. We guess this trick may work in the short term, but in the long run, we have our reservations. The trick is this: increase the interest rates on the bank reserves. How will it work in theory?

You see, traditionally, the Fed did not pay interests on bank reserves. As we mentioned before in How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate,

… the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ?productive.?

In the post-GFC world, the Fed pays interests on bank reserves. If you are a commercial bank, you will only lend money to someone if the returns on the loan is greater than the returns on your reserves. Therefore, the more the Fed increases the interest rates on your reserves, the less likely you will lend it out. That will result in short-term interest rates to rise.

As you can see by now, because of the dysfunction of the financial system post-GFC, the Fed Fund Rate has less and less influence on short-term interest rates. Instead, the bank reserves interest rates become a more effect control.

The question is, will the Fed’s trick work? We will talk more in the next articles. Keep in tune.

Putting the politicians on notice

Sunday, October 18th, 2009

Over the weekend, the Reserve Bank of Australia (RBA) governor, Glenn Stevens, surprised the financial markets with his unusually hawkish stand on interest rates. In response, as this news article reported,

Financial markets responded by pricing in the most rapid series of interest rate rises Australia has seen for 15 years. Markets now predict that the Reserve board will raise rates at seven consecutive meetings, lifting its cash rate from 3 per cent 10 days ago to 4.75 per cent by May and 5 per cent by July.

As we wrote back in July (see How are central bankers going to deal with asset bubbles?), under the influence of William White of the Bank for International Settlements (which is dubbed as the central bankers’ central bank), there’s a sea-change in central bankers’ thinking. Glenn Steven’s aggressiveness is the result of such a sea-change. Our long-time readers should not be caught by surprise at this, unlike the financial markets.

Economists like Professor Steve Keen reckons that if the RBA really carry through its threat that way, it will be a big mistake. The problem with monetary policy is that it is an extremely blunt instrument. Though rising interest rates can put a brake onto the growth of dangerous debt-fuelled asset bubbles, it will also constrict other sectors of the productive economy as well. The risk is that the productive sectors of the economy may be crippled, bringing down the rest of the economy along with it, and as a result, burst the existing asset bubbles in a spectacular way.

Therefore, what is needed is a very precise tool that can target asset bubbles specifically while leaving the rest of the economy alone. Unfortunately, the RBA do not have the power to to enact such a precise policy tool- they can only change the interest rates lever. On the other hand, the arm of the government that are controlled by politicians has the power to formulate such a tool. Very unfortunately, we have politicians who are unwilling to attack asset price bubbles (and worse still, inflate the bubble even more), due in part to control of vested interests and fear of losing elections.

The outcome is that we will have politicians (both at the State and Federal level) and the central bank engaging in policies that are uncoordinated and mutually incompatible. Unless that change, there’s a significant risk of loss of control of the economy by the government. Should this happen, the most convenient scapegoat will be Glenn Stevens as he will be accused as the man who bust up the Australian economy. But for us, we will point the finger at the Rudd government because they understood what the root cause of the GFC (see the essay written by Kevin Rudd here) but instead, not only did nothing to deal with Australia’s towering debt levels, but also introduced policies that increase the risk of a home-grown credit crisis in Australia (the most notorious is the FHOG). The State governments are not any better either.

The politicians must be put on notice.

Can China raise interest rates to control its property bubble?

Tuesday, September 8th, 2009

Currently, the global economy is at a sweet spot. Price inflation seems under control even though copious amount of money is printed in bailouts and stimulus. Asset prices are rising again and there’s hope that the global economy is returning back to growth soon. Just 6 months ago, the markets were staring into the abyss of a Greater Depression. Today, it’s blue skies and green shoots ahead.

In China, though Chinese stocks had deflated somewhat, Chinese property are still rising rapidly, thanks to their bubble blowing policies (see How big is the credit bubble in China?). The Chinese government are well-aware that there’s a property bubble in their economy. And they are also aware that it was the low interest rates and easy money from the Greenspan era that precipitated the GFC by artificially inflating asset prices with debt. They acknowledged that it was a mistake to use interest rates to ‘control’ price inflation and let asset prices run away into an almighty bubble. This acknowledgement is hardly new. As we wrote before in How are central bankers going to deal with asset bubbles?, central bankers have repudiated Greenspan’s doctrine (and that explains why Greenspan is silent nowadays). But the PBOC has a problem- they cannot raise interest rates easily.


It’s thanks to their managed exchange rates. To understand why, imagine you are a hedge fund manager. What will happen if China raise interest rates? Given that short-term interest rates are effectively zero in the US, this makes a very ideal carry trade- borrow almost for free in the US, send the money to China and put it into a Chinese bank, collect interest payment and repatriate the profits back into the US. If you are aggressive for higher returns, you may want to put the money into riskier assets (e.g. bubbly property). Since the exchange rate is more or less fixed and controlled, there is no fear for an adverse currency movement to turn this carry trade into a loss-making business.

In essence, if China raises interest rates, it will attract hot money into the country, which risks further inflation of asset price bubbles. China can’t raise interest rates unless the US does. Since we don’t see the US raising their interest rates any time soon (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view), we doubt China will be raising theirs soon too.

How are governments driving up fixed mortgage rates?

Thursday, April 23rd, 2009

Newton’s Third Law of Motion says that for every action, there is an equal and opposite reaction. Likewise, in the field of economics and finance, for every government intervention in the financial market, there is always a side-effect (some of them will be unintended).

As Marc Faber reckoned, the bull market for long-term government bonds, which started in the 1980s, has come to an end in late 2008, with a tentative rising trend of long-term government bond yields. With the private sectors all over the world de-leveraging (unwinding of debt) in an unprecedented scale from an unprecedented credit bubble, governments will be forced to fill the slack via bailouts and stimulus. As our of our concerned readers pointed out the government’s “spend, spend, spend” slogan in Can government create jobs?, government budget deficit will be a rising trend all over the world.

Consequently, government borrowings will have to increase (or taxes raised and/or money being printed). In a world where credit is scarce, government demand for credit will make it even scarcer. If the government resort to ‘printing’ money (issuing government bonds from thin air to be sold to central banks who created money from thin air to buy them), concerns about rising long-term government inflation will force long-term government bond yields to go up. As a result, this will result in a trend of rising long-term interest rates.

As fixed rate mortgages tend to follow long-term interest rates, banks will be raising their fixed mortgage rates too.

Central banks helping to increase your insurance premium

Wednesday, April 15th, 2009

Insurance is one of the easiest businesses to understand. Basically, it earns money this way:

  1. Collect insurance premiums
  2. Invest the collected premiums (in insurance jargon, this invested money is known as floats)
  3. Pay out insurance claims

Where are the areas that can go wrong with this kind of business?

One possibility is that it may miscalculate the probability of mishaps and mispriced the insurance premiums charged to customers. As a result, claims on the insurance company overwhelms its ability to pay. The Australian government’s guarantee of bank deposits and funding is akin to providing insurance to the Australian financial system. But as we said before in Australian government?s contingent liability to exceed AU$1 trillion, if the mishaps in the financial system are correlated with each other, the Australian government may find that it has burned a big hole in its pocket. For insurance companies, at least they can buy re-insurance to insure itself from such fiascos. The Australian government, on the other hand, have no re-insurance to insure itself other than the monetary printing press.

The other possibility of what can go wrong can occur when it suffer severe losses in its investment endeavours. That can happen when the investment divisions of insurance companies decide to become cowboys and get involved in sexy derivatives, as in the case of AIG. The more prudent ones keep a substantial portion of its investment portfolio in safe bonds and other fixed interest securities. That’s where central bankers are not helping. By cutting interest rates to below price inflation rate, the investment returns of insurance companies get eroded. Along with rising value of claims due to price inflation (e.g. rising health care costs for health insurance), their profit margins get squeezed, sometimes so severely that they can suffer losses.

So, guess what insurance companies will do in that case? They raise the premiums that all of us pay. Cutting interest rates may be good for borrowers, but as everything else in life, there is no such thing as a free lunch.

If you save, government will wage economic war on you

Tuesday, February 17th, 2009

In this economic climate of uncertainty, governments all over the world have to be seen to be doing something. The problem is, by doing ‘something,’ they are actually making the problem worse (see Are government interventions the first steps towards corruption & inefficiencies? and Supplying never-ending drugs till stagflation). In particular, they fear debt deflation because it is the more immediate threat. It is this fear that led Helicopter Ben (i.e. Ben Bernanke) to subscribe to the Zimbabwean school of economic thought (see Bernankeism and hyper-inflation) in the Keynesian belief that forcing people to spend and consume is the way to go. If printing money are the answers to the Global Financial Crisis (GFC), then Zimbabwe will be the richest and most prosperous nation in the world. Indeed, judging by the number of billionaires, in that country, it must be so! When you see Zimbabwe’s central banker praising the central banks of US and UK (see Zimbabwe?s central banker in praise of Fed), you know something is very wrong with the monetary policy of the Federal Reserve.

As we said before in “Government?s contradictory messages,”

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.

Thus, whether you are currently in debt or not, if you intend to save money, the government will be very keen to discourage you from doing so by undermining and debasing the currency in which your savings are based on. As we said in “When real interest rates is below zero, why save money in bank?

 … if we disregard the doctored statistics of the official figures, real interest rates are negative!

That is why governments all over the world are sending so many mixed messages to the effect that an average person do not know whether he/she is meant to spend or to save (see Government?s contradictory messages). A very simple way to resolve this paradox (sarcastically) is to think of it this way: save while everyone else is committing financial suicide by spending willy nilly.

What if you are a saver who simply does not wish to spend, invest, borrow or speculate? If you believe that the government will fight this war against debt deflation by marching our credit-based economy towards a Zimbabwean-style economy (see Recipe for hyperinflation), you will be forced to make very difficult choices. For such a saver, the best case scenario for your savings will be severe price deflation in an environment of zero-interest rates in a properly functioning banking system (while still employed/business earning positive cash-flow). But if you are pessimistic about this best-case scenario happening, then you will be forced to ‘speculate.’

As the government and RBA try to erode your savings by taxing them and pushing down interest rates to below price inflation (even perhaps to zero), what can you do? Good question.

Let’s take a look at the US. Currently, short-term US Treasury bonds are yielding almost nothing. At one point, their yield even became negative! In that case, what will be the difference between a nothing-yielding government bond and gold? As we said before in “Is gold an investment?“, gold is

a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ?investment.?

That probably explains why we are seeing, at least for now, US Treasury bonds and gold moving upwards together. Traditionally, they move in opposite directions. Today, this inverse relationship seems to have decoupled.

Therefore, the risk/reward profile has come to the point that savers who have spare cash may want to consider transforming part of their savings from cash to gold.

P.S. Use the government’s free stimulus cash to buy gold. 😉

When real interest rates is below zero, why save money in bank?

Sunday, February 15th, 2009

In “What will happen if RBA cuts to zero?,” we described the situation whereby interest rates in many countries are moving towards zero i.e. Zero Interest Rate Policy (ZIRP). In Australia, the interest rates are currently at 3.25%. There are talk in the financial market that more cuts are on the way.

Price inflation, on the other hand, is 3.7% for the year to December 2008- that is, according to the official CPI figures. As late as October last year, the official price inflation was running at 5%. But as we wrote in “What is your personal price inflation rate?,”

Inflation is also running high in the rest of the Western world. Worse still, many of the official measurements of inflation run counter to personal experiences.

As we quoted Ludwig von Mises in How much can we trust the price indices (e.g. CPI)?,

If she [a judicious housewife] ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

Talking to some people from the US, we learnt that despite having an official falling inflation rate (based on CPI), people feel that things are still very expensive.

In other words, if we disregard the doctored statistics of the official figures, real interest rates are negative!

In Australia, interests from savings are taxed. This means that after tax, putting money in the bank is a losing proposition. If excessive debt is the cause of the global financial crisis (GFC), then this means that the solution is to slim down, cut down on debt and start saving. But if savers are punished with negative real interest rates, then the very poison (that caused the crisis in the first place) is used as the medicine. If a doctor do this, then he/she will be charged with criminal negligence. Yet, with interest rates in Australia projecting to fall further, the econocrats are doing this!

For foreigners, the solution is very simple- just pull your capital out of Australia. After all, who on earth will want to lend money below the rate of price inflation? If the government is really concerned about the foreign banks pulling out of Australia (and further tightening the local credit market), then wouldn’t falling interest rates worsen the situation? It has come to the point that even our local banks are murmuring about further cutting their lending rates to match RBA’s projected rate cuts. If the banks are politically pressured to cut their mortgage rate, then they will have to: (1) draw blood from elsewhere- see Canberra is destroying jobs or (2) ration capital.

For the hard-working Aussie savers, what are their options? We will look more into it in the next article. Keep in tune!

What will happen if RBA cuts to zero?

Tuesday, February 10th, 2009

In the United States, the Federal Reserve had set the interest rates to almost zero. In the United Kingdom, interest rates have reached 1%. Japan had cut her interest back to almost zero again. Canada’s interest rates have reached 1%. In Europe, it’s 2%. All over the world, central bankers are busily firing their interest rates guns to fight this global recession. Already, Japan and the United States had already ran out of ammunition.

As for Australia, the goods news is that our Reserve Bank of Australia (RBA) still has some ammunition remaining after cutting its rates to a low of 3.25%. The bad news is that Australia is about to enter recession, possibly a very severe one (see Realisation of hard landing ahead for Australia). So, what if Australia’s RBA runs out of ammunition too?

If Australia’s interest rates ever reach zero (as Professor Steve Keen believes it will by 2010), it will happen in the context of a hard landing or even a depression. It will be a time of debt deflation, which as we said in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

Chances are, such economic malaise will drag on for many years, similar in length to Japan’s lost decade. For investors, this will be a very trying time. The key thing for investors and savers to watch out for is the Aussie dollar. As we explained before in Can falling interest rates and rising mortgage rate come together?,

A large fraction of Australia?s borrowed money is sourced from overseas through the ?shadow? banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

As a result, there is a great potential for a complication that we described in Another complication in RBA?s interest rate cut,

Today, we will talk about another issue that can complicate matters for the RBA- the pullout of foreign capital.

When debt deflation takes hold of Australia, the RBA can easily run out of ammunition. In the absence of government intervention, credit will be extremely scarce in Australia. Our guess is that in such a scenario, foreign capital will flee out of Australia, leading to another fall in the Aussie dollar. The only mitigation against our dollar in such a scenario will be to the extent that the Australian government opens up our mining and resource assets to predatory foreign sovereign wealth fund (read: China).

Everything else being equal (we will talk about the not-being-equal scenario further down), a falling dollar will be, as we described in Falling currency and inflation,

Now, we will look at the context of Australia, which is another import-dependent country. A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

Now, imagine the food that you eat everyday. Most of them are produced in Australia. A falling Aussie dollar implies that foreigners will have greater purchasing power for Australian-made food. Assuming that the market is still free, that means that Australians will have to compete with foreigners for our own food. Also, since Australia is hardly self-sufficient in manufactured goods, a falling Aussie dollar will imply falling purchasing power for the many imported things that we enjoy today.

What if we combine debt deflation with falling Aussie dollar? In that case, there will be massive aggregate demand destruction in the economy. Basically, this means a very drastic drop in the standards of living for many.

We shudder to think of the implication of this. We wonder whether there can be a scenario whereby there is a combination of (1) crashing asset prices (due to debt deflation) and (2) rising inflation for price inelastic consumer staples (due to the depreciating Aussie dollar)? If such an mishap eventuates, even savers have to worry about the return of their savings!