Cyclical v Structural change

[Judge]

One question really puzzles me at the moment, and i wonder what the learned and respected folks on this forum think on this topic.

Whenever interest rates were discussed in the past the discussion has always been around where we are in the cycle of interest rates. If the rates are very high now, it means them must head lower going forward. And equally after a period of low rates, the expectation has been that the rates will increase going forward. This is how it has been, this is how it will be.... Or will it?

In a few articles recently, i have read that the current change to the interest rates framework in NZ is not cyclical, but structural. That is, the reduction of rates is not following a cycle, but rather settling into a new pattern which is structurally different from what we got used to previously. The rates may not go up in the future. They may stay where they are for a long time. or they may get lower. Or a bit higher, but nothing like the cycles we have seen before.

Personally i am not sure what to think. Certainly something in the world is changing. Who could have predicted that despite all the easing and money printing in the world there will be no inflation (or that there will be deflation)? Who could have predicted 2-3 years ago that the price of oil is going to be where it is now, and the current predictions are that it will go as low as $30 a barrel? What about the price of Iron?

Historically NZ had very high interest rates compared to the rest of the world and there were certain reasons for it. But may be these reasons are no longer at play and we are just joining the rest of the world where normal rates are about 2% rather than 7%? If this is true, it is likely to have profound effect on the NZ economy generally and NZ property specifically. The question is whether we are in a new environment or just an unusually low bottom of the usual NZ cycle or rates... I tend to think the change is structural. There is just too much strange and unusual change happening in the world for us to assume that we will continue in the same pattern that we followed for the last 30 or however many years. But my view is more of a gut feel based on some uneducated research. Nothing more than that yet.

[Bob Kane]

Yep - structural change in interest rates. We'll have low interest rates for the next 10 years.

[donna]

Very interesting read - thanks Judge.

If the current property values are affordable then it's unlikely they'll drop (in Auckland) rather there may be a levelling off for some property types and areas while units, apartments and the not so popular areas continue upwards for some time to come.

The regions will follow a similar trend to Auckland but on a smaller scale - i.e. property values rise fastest in the popular areas

cheers,

Donna

[marklowes]

One question really puzzles me at the moment, and i wonder what the learned and respected folks on this forum think on this topic.

Whenever interest rates were discussed in the past the discussion has always been around where we are in the cycle of interest rates. If the rates are very high now, it means them must head lower going forward. And equally after a period of low rates, the expectation has been that the rates will increase going forward. This is how it has been, this is how it will be.... Or will it?

In a few articles recently, i have read that the current change to the interest rates framework in NZ is not cyclical, but structural. That is, the reduction of rates is not following a cycle, but rather settling into a new pattern which is structurally different from what we got used to previously. The rates may not go up in the future. They may stay where they are for a long time. or they may get lower. Or a bit higher, but nothing like the cycles we have seen before.

Personally i am not sure what to think. Certainly something in the world is changing. Who could have predicted that despite all the easing and money printing in the world there will be no inflation (or that there will be deflation)? Who could have predicted 2-3 years ago that the price of oil is going to be where it is now, and the current predictions are that it will go as low as $30 a barrel? What about the price of Iron?

Historically NZ had very high interest rates compared to the rest of the world and there were certain reasons for it. But may be these reasons are no longer at play and we are just joining the rest of the world where normal rates are about 2% rather than 7%? If this is true, it is likely to have profound effect on the NZ economy generally and NZ property specifically. The question is whether we are in a new environment or just an unusually low bottom of the usual NZ cycle or rates... I tend to think the change is structural. There is just too much strange and unusual change happening in the world for us to assume that we will continue in the same pattern that we followed for the last 30 or however many years. But my view is more of a gut feel based on some uneducated research. Nothing more than that yet.

Stucturally different to anything we have seen before is my guess.

FED has never gone so long without raising rates.

If it wasnt for the massive QE we may have seen another 1930s style despression.

What a lot of people have been seeing from the QE is all the money flowing into assets and not being used all that productively (doubts on global demand if used to expand business, easier to buy back stock which a lot of big US companies have been doing, equity more valuable than debt currently, so borrow and buy back equity, who needs public investors funding things when debts so cheap?). So its going into assets and not into fueling global growth that might actually lead to inflation.

Also if you value assets based on the net present value (NPV) of all future earnings then you use a discount rate on those future earnings to adjust for the time cost of money (eg 1k today worth a lot more than 1k earnt 5 years from now). Lower interest rates = lower discount rate, eg that 1k earnt 5 years from now might = $800 in a lower interest rate environment, whereas in the 2000 decade it would be discounted a lot more, prehaps having a NPV closer to $500.

A simplier way of looking at this would be the yields now required to get a neutrally geared property. If the new normal is 4%-7% interest rate cycles, as opposed to 7%-10% as in 2000s then required yields might be some 3% less.

To see the impact of this on a house returning $500 a week rent:

At acceptable yields of 8% (maybe 2000s rates level) = $325k the max price you'd want to pay for the house (500x52/(0.08 )

At acceptable yield of 5% (if the new normal is lower rates from here on out) = $520k the max price you'd want to pay for the house (500x52/(0.05)).

[Damap]

Great post Judge. If structural then that is bad news for the government as investors will accept lower and lower yields driving interest rates even higher. This is kind of what happens in Oz isn't it where their rates have been lower than ours for many moons.
Makes predictions about the bottom of interest rates rather difficult too!

Is it possible the planet can manage well on low interest rates? i guess the answers yes providing banks remain profitable.

[PTILoveYou]

The lower the interest rate for longer, the more difficult it is to increase.

If rates go from 7 to 10%, that's 30% increase.

If rates go from 2 to 4%, that's 100% increase.

Businesses who forecast their borrowings and cashflow on low interest rates will struggle if rates go up big and quick.

[Wayne]

The lower the interest rate for longer, the more difficult it is to increase.

If rates go from 7 to 10%, that's 30% increase.

If rates go from 2 to 4%, that's 100% increase.

Businesses who forecast their borrowings and cashflow on low interest rates will struggle if rates go up big and quick.

It may be difficult on the people but pretty easy to increase.
They will move up when money becomes more scarce without looking at how it will affect NZ borrowers.
It will be a global move.
This is one reason for the Feds current reluctance to increase their rate - if they move too fast business will struggle, the economy could stall, then they will have to drop again to get it moving.

[Damap]

Unless Judge's hypothesis is correct in which case they may never rise dramatically.

[spaceman]

Warning warning ...maths nerd alert

The lower the interest rate for longer, the more difficult it is to increase.

If rates go from 7 to 10%, that's 30% increase.

If rates go from 2 to 4%, that's 100% increase.

Businesses who forecast their borrowings and cashflow on low interest rates will struggle if rates go up big and quick.

7% to 10% isn't 30% increase.....it's a 42.8% increase

7% +30% = 9.1%

Cheers
Spaceman

[PTILoveYou]

It may be difficult on the people but pretty easy to increase.
They will move up when money becomes more scarce without looking at how it will affect NZ borrowers.
It will be a global move.
This is one reason for the Feds current reluctance to increase their rate - if they move too fast business will struggle, the economy could stall, then they will have to drop again to get it moving.

Yes easy to move, but the impacts could be substantial.

[PTILoveYou]

Warning warning ...maths nerd alert



7% to 10% isn't 30% increase.....it's a 42.8% increase

7% +30% = 9.1%

Cheers
Spaceman

You got me, I didn't bother to use my calculator, but you get my point

[Damap]

From Forbes. Makes sense.

The effect of Fed policy on the national debt, the deficit, and the federal budget cannot be overestimated. The Fed has, in fact, served as the largest-scale enabler in history, assisting the President and Congress to run a series of the six largest budget deficits the nation has ever seen.

Historically, normal interest rates for U.S. government debt is in the range of 4 to 6%. In fact, before the recent recession both 2 and 10 year government bonds had been between 4.5 and 5.25% for the preceding two years. Rates now are approximately 0.5% for the 2 year note and 2% for the 10 year bond. The difference between the cost of the national debt at current rates and historically average ones is enormous.

For the fiscal year 2014 that ended last September, the federal government paid $430.8 billion in interest on the national debt. Back in 2004 with “only” $7.3 trillion in debt, the interest bill added up to $321.6 billion. With only 40% as much debt, the government was paying 75% as much in interest. If the federal government was currently paying an historically average interest rate on the debt, instead of $431 billion in interest the annual bill would be around $900 billion.

In other words, normal interest rates would double the current federal budget deficit and make any effort to contain the national debt far more difficult.
The Fed has enabled out-of-control federal spending and borrowing in a second way. As part of its quantitative easing policy (commonly known as QE) the Fed has bought up trillions of dollars in government bonds. While the federal government pays the Fed interest on these bonds, the Fed refunds its annual operating profit to the Treasury so essentially the interest on all those bonds is returned to the Treasury.

Because the Fed is basically allowing the government to borrow several trillion dollars interest free, the Fed’s QE programs have saved the government several hundred billion dollars, thereby lowering both the deficit and national debt. For example, in 2014 the Fed refunded $98.7 billion to the Treasury. At least for now the Fed has ended QE, but it has announced no plans to shrink its balance sheet. Thus, the Fed’s subsidy to the government apparently will continue to hold down the deficit for a while longer.

What all this means is that even if rates rise, they won’t rise much. The Washington politicians do not want to see deficits spike by $500 billion per year unless they get to spend that money on programs of their choice. There may be value in reading the Fed’s regular policy statements in order to properly position your investment portfolio, but when they promise higher interest rates I would take that part with a grain of salt.

So if you are a saver weary of the paltry interest you have been earning on bank accounts, certificates of deposit, and many bonds, you probably are looking forward to the Fed raising rates. Unfortunately, there are 18 trillion reasons why rates may never return to normal levels. Given the current economic condition and the potential impact on the deficit, if the Fed did actually put serious effort into raising interest rates, the President would likely tell them to stop.
Wall Street wisdom says never to fight the Fed, but on interest rates we have a battle the markets seem to think they will win.

[PTILoveYou]

Thanks for the share Dean.

Nice business model, printing to spend, never ending cycle of debt binge...

[Wayne]

Yes easy to move, but the impacts could be substantial.

Which is what I said.
Move too fast and the economy snarls up again.
But don't think they won't move.
Now 4-5% and could easily become 6-8% and ruin a few peoples business model.
But will they - only time will tell. They have been low for quite a while and seems they will stay low for some time yet.
We are currently living what people will be refering to in 20-30 years.

[Wayne]

Thanks for the share Dean.

Nice business model, printing to spend, never ending cycle of debt binge...

It seems it is.
The logic in the article is inescapable and I can't help feeling that it is just all too good to be true.
I think something will happen and give a nasty shock.
If you survive the shock things will be great.
A bit like the GFC - those that survived the GFC with their shirt on are now buying nice jackets.
Those who lost their shirt struggle.
Getting through the shock was the key.