There is an old bond trader joke that I first heard in the 1980’s when I traded mortgage-backed securities at Drexel Burnham Lambert. It went like this: “Upon dying, Albert Einstein finds himself in what he is told is heaven. He encounters another individual there and asks him what his IQ is. When he is told that it is 175 he is overjoyed, knowing that he’s found an intellectual peer with whom he can share much. Upon meeting another, he discovers that person’s IQ is 140 and is pleased to have met another highly intelligent person with whom he can enjoy chess and other pursuits. He is feeling pretty good about heaven, when he comes across a person who tells him that his IQ is a mere 90, and he is flummoxed. What, he wonders, is this guy doing in my heaven and what can I even say to this person? Then it comes to him. ‘Where,’ he asks, ‘do you think interest rates are heading?’”
This joke is both humorous and insightful into the market of the past in that it tells us that in the 1980’s it was thought to be idiotic to forecast rates. There was an understanding among pro’s that interest rates are determined by the tug of war of powerful countervailing forces, and that guessing which of those forces would prevail in any moment was not possible. These forces made up what is referred to by old-timers like me as “the free market.”
Today, this joke has little relevance, because unlike the past, when the forces of the free market largely dominated things, now rates are mostly the result of government’s needs and manipulations. In response to the financial crisis of 2008 the Fed began to intrude into the market in a way that was unimaginable, and in short order its heavy-handedness was emulated by all global central banks. What was unimaginable prior to 2008 is now commonly accepted, and this might be most shocking of all. Einstein, or even lesser lights like us, now need to only to ask one simple question when seeking to determine where rates are heading – “Where does the government need them to be?” And, in a world awash with debt it needs them to be very, very low.
U.S. household debt is rapidly approaching 2008’s peak level and is on pace to exceed it by this year’s 3rd quarter. Global debt, according to J.P. Morgan, has risen from 221% of global GDP at the end of 2008 to 242% at the end of this year’s 1st quarter. But, thanks to the miracle of ultra low rates, the cost of servicing this higher debt load has actually fallen by about 36% when measured against GDP, from a peak of 11% to now 7%.
Clearly, whether by design or instinct, the governments of the world are reacting to the dearth of economic vibrancy by increasing debt levels and allocating capital to support those who need help. Make no mistake about it though, this is a zero sum game and those with savings are the ones who are paying the bill here as they are forced to accept lower, and even no return on their savings. This has been the reality for the past seven years, and there is absolutely nothing on the horizon that should lead one to expect things to change anytime soon. Japan is the poster child for this way of life. With three decades of economic stagnation, and having relied on central bank manipulation for that long, they have run up their debt level to about 400% of GDP, yet with rates having been near zero for so long, and now negative, their interest cost-to-GDP is about 2%, according to J.P. Morgan, and is about the lowest in the world. This, it would seem, is the new normal that we must recalibrate to, and it will surely lead to many structural changes in the investment world in the years to come.