Jul 132020
 

The new normal

low interest rates will lead to greater economic expansion, but also more debt.

The year is 2030. Self driving cars are delivering fast food right to people’s front doors. China surpasses the U.S. as the world’s largest economy. Everyone uses mobile wallets instead of credit cards. Increasing wealth inequality has created constant social unrest. But one thing hasn’t changed. Interest rates continue to remain at rock bottom. You can still get a mortgage for less than 2.5%. ๐Ÿ™‚

The economy has fallen into a deep pit of debt – so deep you can find Adele rolling in it. Policy makers around the world manufactured liquidity and bailed out corporations. Everyone has become accustomed to cheap money. If interest rates were to climb by just 1% then a third of mortgages will become delinquent.

 

Inflating money with impunity

Today in 2020 the United States government is already technically insolvent. But it can continue to make its debt payments because…

  • It has the ability to borrow money from a line of credit with no credit limit. And..
  • It can choose the interest rate at which it borrows thanks to the Federal Reserve.

From the total revenue collected by the U.S. federal government, 17% of it is used to pay interest on the debt it owes. If interest rates were to rise by just 1% then nearly a quarter of the federal revenue will have to go towards interest costs. That would be insane. Doing so would be the equivalent of someone with a $50,000 salary taking on a $500,000 mortgage at 2.5% interest rate. Nobody can qualify for a mortgage 10x their annual income. Even if the borrower thinks he can afford it, good luck finding a lender audacious enough to approve his loan application. Most mortgages are only 3 to 5 times one’s income.

Typically if a debtor starts to borrow more than he can adequately service – market forces will begin to push back. Lenders will either reject any new credit increase requests, or they will raise the interest rate to compensate for the debtor becoming a higher risk. But this doesn’t happen for governments with their own printing presses. The result: massive asset price inflation.

low interest rates are good for the stock market.

 

The lost decade

From 2010 to 2020 policies makers did try to normalize interest rates. But it was a catastrophe. As soon as rates went up they tumbled back down again.

  • European rates were raised by 0.50% in 2011 before being dropped by 1.50% to zero.
  • Canada had better luck increasing the benchmark rate by 1.25%. But then had to cut it by 1.50%.
  • The U.S. was the most hawkish and managed to raise rates by 2.5% – before dropping them by 2.5%.

So after 12 years of “recovery” since the 2008 financial meltdown the world is back to square one today. Any extended period of higher interest rates just couldn’t be sustained.

 

The next 10 years

Some may blame today’s low interest rates on a disease that’s been going around. But the virus was only the pin that pricked the precarious bubble we were already in. If it wasn’t a pandemic it would have been something else. It wasn’t hard to predict this recession. The signs were already there 2 years ago.

The longer interest rates remain low the more ๐Ÿ’ฒ people will borrow. That’s exactly what we’re seeing in the real estate market. Mortgage debt growth has exploded and helped fuel higher housing prices. Canadians owe literally twice as much mortgage debt today as compared to 2008. In other words, it took all of Canada’s 100+ years of history up to 2008 to accumulate $800 billion of mortgage debt. Then it took just 12 more years to build up another $800 billion. Oh man. That is a scary reality. ๐Ÿ˜ฎ

It took 4 decades for Canadians toย build up $800 billion of mortgage debt. And then 12 more years for the next $8 00 billion.

This can only mean one thing. Low interest rates are here to stay for at least 10 more years. Prepare for low mortgage rates and low bond yields all the way to the 2030 Olympics. This is the new normal. It’s great news if you’re a borrower. Bad news if you’re a saver.

 

Looking forward

Policy makers tried to normalize rates before and evidently failed. Is there any reason to believe they will succeed on their next attempt when the economy will be even more entrenched in debt? Nope. Both governments and consumers have become too reliant on cheap money. Any attempt to raise rates in the short and medium term will surely backfire.

Politicians take care of the economy like grandparents take care of small children for the weekend. They just want to be liked and revered in the present. That’s why they do what’s expedient instead of what’s responsible. But a lack of discipline will eventually lead to disaster. But that’s fine. They won’t be responsible anymore when the consequences come due.

The only way out of this perennial cheap credit cycle is a major shock to the underlying economic system itself. This could mean a restructuring of government debt, an accelerated increase in the cost of living, or a new world reserve currency.

In any case, I plan to continue buying hard assets and infrastructure companies. All this is just conjecture. But if rates really do stay low for the next 10 years then I want to be prepared. ๐Ÿ™‚ That’s why I’m looking to purchase another real estate property before the end of this year. ๐Ÿ 

What are you doing with your money these days?

 

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RICARDO
RICARDO
07/13/2020 10:12 am

I think you mean that it has to get to minus 274C before they pay off the debt. I think hell will freeze over before then.
What i want to know is when the monetary system will drop the US$ because it is worthless.

RICARDO

GYM
07/14/2020 9:28 pm

Ughh…cheap borrowing. Definitely punishing the savers. We are thinking of getting a condo or something in Hawaii but their HOA fees are so high.

Family Money Saver
07/14/2020 9:55 pm

I know a guy named Tony that can get you that ’10x your income’ mortgage. But it’s a variable rate and has no skip-a-payment option.

Seems like something has to give eventually with so many people over-extended on their homes. Look at COVID for example – what would have happened with no government support.

Crowbar
Crowbar
07/16/2020 7:08 am

I don’t necessarily disagree with your analysis Liquid. We probably do have at least 5 to 10 years of cheap interest ahead of us.

But I would like to point out that the monetary policy by the central bank is largely driven by forecasted inflation. If we do succeed in printing & borrowing up a storm, and if 2%+ inflation becomes structural; the central bank will have no choice but to raise interest rates in response.

Think it can’t be done because consumers are over-leveraged? Ask anybody with a mortgage in the 1980s if the central bank asked their opinion before they aggressively increased rates to cool-off the structural inflation cycle.

Curious
Curious
08/01/2020 4:02 am

Which begs the question, what is your plan? ๐Ÿ™‚ If you’re investing in illiquid real estate and there is an aggressive rise in interest rates, how will you service your debt payments?

Maria @ Handful of Thoughts
07/16/2020 2:55 pm

You are so right – low interest rates suck for savers but are good for borrowers – at least those who can afford the payments.

I really wish that we didn’t have so many fixed rate mortgages. We locked them in last year when we thought rates would “never go lower” (insert face palm). Oh well, they are still locked in at great rates and the tenants are paying for them. Can’t complain too much.

Alain
07/17/2020 9:28 am

I never buy bonds. I only buy broad based indexed ETFS.
I think the US will stop being the reserve currency of the world. I think China will take that place. I did real estate for a few years, but prefer index funds. I am happy to give up some returns in exchange of liquidity and simplicity of not having to do anything to make a few dollars.

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Paul Jones
Paul Jones
07/21/2020 6:32 pm

Lyn Alden has a good perspective on the macro-implications of the US debt (she’s on twitter). She expects the US treasury to artificially lock the yields of the bonds at a low rate by constantly buying them. This allows them to jack inflation, devaluing the debt, while keep bond rates low. As for the new global currency, she expects US to hold that torch for a while longer. No other country is as stable as the USA, nor is their economy big enough to be the ‘new global currency’. What might happen is a basket of currencies is adopted instead. This has been attempted before, but was shutdown by America. This time, it might go through.

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