A financial black hole is sucking in central banks
Nothing can escape the gravitational pull of zero rates, and monetary policy will soon swing back to it
In physics, escape velocity is the velocity needed to escape the gravity of a planet.” This 2014 comment was made by the then Governor of the Bank of England. Mark Carney argued that ultra-easy money would kick the economy out of its stupor Post-crisis It didn’t happen As his successor, Andrew Bailey, is discovering, zero-rate policy is more like a black hole, a monstrous dead star whose gravitational pull is so powerful that nothing can escape its grasp.
Central banks want to lower inflation by returning rates to normal levels. The Bank of England’s rate of 2.25% is just over a third of its average post-war level. Despite rising sharply this year, to around 4.5%, 10-year debt yields are still more than 5 percentage points below inflation. But the British economy and financial system are beginning to falter. To see why, consider the exposure of households, governments and companies.
The British like to complain about how super expensive houses are. The reality is that mortgage costs in recent years have been extremely low. Home buyers responded to the availability of cheap loans by taking on more debt. Thus, the average mortgage has grown to 3.4 times the average income, compared to 1.5 times in the early eighties, according to housing analyst Neal Hudson.
This was tolerable with 2021 mortgage rates at 2%. But it has left many homeowners extremely vulnerable to higher rates. Earlier this month, the cost of a two-year fixed-rate mortgage shot up to 6%. 1.5 million of these loans will reset to the higher rate in the next 12 months. To restore affordability, home prices may have to fall by more than a third, Hudson estimates.
The Government is in a similar situation. The lockdowns produced the largest peacetime fiscal deficits ever seen. The state financed the deficit with the lowest borrowing costs since the opening of the Bank of England in 1694. Since 2007, the British national debt has gone from 34% to 95% of GDP. But government debt service payments as a proportion of tax revenue have fallen by almost half. In 2021, the State paid 1.1% for its loans, compared to the 5.8% it paid before the 2008 crisis.
The Bank of England lent a hand. He not only cut his rate to almost zero: he also bought large amounts of public debt. He still owns 840,000 million pounds (970,000 million euros). Bond yields fell, lowering the cost of new debt. The Bank also remitted to the Treasury the interest payments it received on its bond holdings, charging just 10 basis points in 2021 for its huge loan to the government.
Central banks tend to view quantitative easing as a monetary operation. But from the financial point of view it means exchanging debt at a fixed rate for another at a variable rate. According to a 2021 House of Lords report, Bank of England security purchases reduced the average effective maturity profile of government debt from nearly 15 years in 2007 to just over 10 years. So the government’s fiscal position is more exposed to rate fluctuations. “Lower short-term rates are more quickly reflected in government borrowing costs,” concluded the Lords’ committee, whose members include former central banker Mervyn King.
The UK Office for Budget Responsibility estimated in 2021 that a one point rise in rates would raise the cost of servicing public debt by almost 1% of GDP. If the government borrowed at its average historical rate of 6%, debt servicing costs would consume 16% of tax revenue, more than five times last year’s level.
Corporate debt has also risen sharply around the world. While the level of debt of UK non-financial companies (relative to GDP) fell slightly after 2008, those in the US have gone on a lending binge. Business credit there exceeds 80% of GDP, 15 points more than in 2008, according to the Bank for International Settlements. But its debt service costs have fallen.
The quality of US corporate debt has also deteriorated sharply. Half of investment-grade corporate debt now has a triple B rating, just one notch above junk. In 2021, private equity closed deals for more than a trillion dollars, while acquisitions of US listed companies reached a record profit multiple, according to Bain. The purchases are financed in part by leveraged loans whose interest payments are linked to short-term rates.
Until recently, investors had an almost limitless appetite for this type of debt. Low, risk-free rates drove savings out of banks and into credit markets, where returns were higher. Since 2007, US credit funds have enjoyed nearly 3 trillion inflows. Unexpected monetary tightening and the prospect of a recession pose a challenge for these funds, especially those that have to shed assets when investors pull out. “Liquidity tends to be high when there are a lot of buyers, but not so much when there are a lot of sellers, especially in credit,” says investment strategist Gerard Minack, who fears volatility will rise as corporate defaults grow. . The recent turmoil in gilts prompted several UK property funds to restrict redemptions to investors.
After 2008, developed economies never reached the escape velocity necessary for central banks to normalize monetary policy. It is now clear that rates cannot be returned to their historical standards without house prices plummeting, government finances undermined and credit markets roiled. The Bank of England has not only failed to raise rates in line with inflation, but has repeatedly intervened to prop up markets. As a financial black hole opens, central banks will be forced to stop tightening rates. The long-awaited turnaround for investors is near.
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