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Friday, 21 June 2013

Ernst's Economy in discussion at BNR Newsroom: Kees de Kort on inflation, low interest rates and the Japan Scenario.

Last Monday, 17 June 2013, I was present again at BNR Newsroom, the semi-live Talk Radio show with its distinguished host Paul van Liempt.

Guests of the evening were, among others, the famous and savvy Dutch macro-economist Kees de Kort of BNR News Radio and Jeroen van den Broek, head of the Credit Strategy department of the ING Groep N.V. (INGA: NA), the largest bank and only global SIFI-bank in The Netherlands.

At the start of this week’s BNR Newsroom episode, the main topic of the discussion was formed by the developments at the international bond markets, where - according to some insiders - broad interest rate hikes seem to be imminent.

Kees de Kort, who is never short of breath AND a well-founded opinion, shared his unique insights about these developments at the bond markets.

Due to the quality and the interest of it, I print a full transcript of this discussion between Paul van Liempt, Kees de Kort, Jeroen van den Broek and Ernst’s Economy. The integral radio show can be heard at BNR News Radio:

Paul van Liempt: we start with the following thesis

‘The end is near for the extremely low interest rates at the bond market’

Paul van Liempt: The interest rates dropped for thirty years, and consequently the bond rates rose during this period. How long will it take before the bond market is finally down and out, due to these predicted interest rate hikes?

Paul van Liempt of BNR Newsroom
Picture copyright of : Ernst Labruyère
Click to enlarge
Kees de Kort: I am not so convinced that the interest rates will rise again. Central banks all over the world (The US, Europe and Japan) managed to bring the interest rates down during the final moments of the bull market. These lower interest rates made it easier to roll over state debt and enabled the banks to earn some extra money.

What they also did, was lowering the offering costs of what we could call the foundation of the risk construct, the sovereign bond. This made it extremely cheap for governments to create new debt, due to the low yields for owners of these bonds. 

The consequences forced a large number of investors to buy other investment tools, as T-Bills and sovereign bonds, as well as 'saving at the bank', didn't yield anything.

Consequently, many rate increases at the international stock exchanges aren't based on fundamental improvements within the real economy at all. To the contrary, these rate hikes are mainly caused, because investors asked themselves: "what can we do to earn a few extra bucks?"

Kees de Kort at BNR Newsroom
Picture copyright of : Ernst Labruyère
Click to enlarge
So, if these days the interest rates on T-Bills and Sovereigns would suddenly go up, then this whole risk construct, with the sovereign bonds as its foundation, will start to shake. 

Not only sovereign bonds would depreciate in value, due to the rising interest rates, but also stock, Commercial Real Estate and other investments which were bought by investors, as an alternative for sovereign bonds. You name it...

Besides that, rolling over state debt will also become much more expensive. This will have serious negative consequences for the debt position of states.

Summarizing: theoretically, the interest rates could go up, but I don't think that the Fed, the ECB and central banks dare to make this bold move.

Then there is the 'story of Japan': what happens today in the US and Europe, has many parallels with what happened in Japan about 15 years ago. The interest rates in Japan have been extremely low for a very long time. I don't say that this scenario will happen in Europe and the US, but it might after all.

The interest rate could meander around the 1.5% to 2%, without large rate hikes, for a very long time, just like in Japan.

Paul: Jeroen van den Broek, when I ask you if the end of the low interest rates at the international bond markets is in sight, do you have the same doubts and fears as Kees?

Jeroen van den Broek: We [the ING Groep N.V. - EL] do indeed have more or less the same doubts as Kees about rate hikes. I am head of the Credit Strategy department of ING. Our competence lies clearly in corporate bonds. Our macro-economists advise us that the official interest rates and the general growth might remain low for a considerable period of time.

Jeroen van den Broek of the ING Credit Strategy dept
Picture copyright of : Ernst Labruyère
Click to enlarge
Most of our reasons for this forecast on our behalf have just been mentioned by Kees.

Kees: And there is one more reason. Growth does not improve yet and the inflation is already dropping for quite some time now. Normally, inflation and interest rates are closely connected. Currently, the inflation is very low and the direction of the movement is still downwards. This is one more reason why the interest rate is not likely to go up shortly. It is my opinion that the interest rate will remain low for a number of years.

Ernst's Economy: Are the low interest rate not a trap, where you can get in quite easily, but from which you can't get out anymore? When a central bank chairman first lowered the official interest rate for a number of times and then wants to raise it again, this will have an immediate negative effect on the economic growth, won't it?!

Kees: The central bankers are stuck between a rock and a hard place! If they raise the interest rates, the economic growth will diminish and it will be much more expensive to roll over state debt. On top of that, the risk construct changes, like I explained before.

However, when the interest rates remain low, which is the situation that we are in today, these low rates will lose their effect on the economy. To be perfectly clear, the results of the current low interest rates and the cheap money for the economy have not been very dramatic, to be honest.

Europe (i.e. the ECB) did a lot to help the economy, with very mediocre results. The US did even more and only managed to get some moderate growth at very high expenses. Also Japan went through years and years of low interest rates and the results are still very disappointing. Like you stated before, we went into the trap and can't get out of it, now. What can we do now?!

A choice must be made between these two evils and both options are extremely unpleasant.

Ernst's Economy: On the other hand, the governments of Europe, Japan and the US printed many billions of Euro's and Dollars in order to increase the money supply in the economy. Will all this excess cash not act as a flywheel that eventually spurs inflation and consequently enables a hike of the most important interest rates?!

Kees: if this would be true, then Japan would already have an inflation of 100%. You should look at what happened in Japan since 1989. Then you will see more and more parallels: large deficits, 'free' money, kicking the can down the road when it comes to problem solving. The interest rate is still low and there is still deflation in Japan.

Money should be spent, but this doesn't happen in Japan. There is this beautiful metaphore: You can bring a horse to a water source, but you can't force it to drink. The money is there, but it is stuck at the banks in Japan. These banks buy sovereign bonds and thus roll-over the state debt, instead of pumping this money into the economy.

And as the saving's rates remain so low in Japan, other people there don't want to save money, but instead buy stock, commodities, gold and silver.

Paul: In other words, Japan is already so much further on this road. Does that automatically mean that in Europe and the US this same proces will take such a long time too?

Kees: At any given time, governments can do something about this process. The question is, however: what are they going to do, actually? Raising the interest rates? In Japan, the recipe for the politicians has been over the years: kicking the can down the road, in order to buy time.

They actually managed to do so: things didn't get worse, but they also didn't get better. Japan remained in a stable situation.

The foundation of my story is: there is too much debt in the society. State debt, mortgage debt, debt on loans. Not only in The Netherlands, but in all countries. What do we do about that?

In Japan, politicians were very reluctant to do anything about this huge national debt. They chose for a scenario of 'muddling through the crisis'.

Jeroen: Don't you think, Kees, that inflation could be very healthy, actually?

Kees: With everything that we do, there are winners and losers. People with high debt do like inflation, as it reduces their debt by making it less valuable. On the other hand, many people have a fixed income and they don't have much debt. For these sensible peope inflation is a punishment, as it erodes their possessions.

Do you want to bring these people to their knees with high inflation, in order to save the people that did crazy things? That is a moral dilemma.

On top of that: Japan is already trying for many years to spur inflation, but until now with very little success.

This was the end of the very valuable discussion at BNR Newsroom on this particular subject.

Summarizing: Kees de Kort and I almost totally agree in the matter of the future development of bond rates, as a consequence of the official interest rates, set by the central banks. Low interest rates are like 'Hotel California': you can check in any time you want, but you can never leave!

Ben Bernanke, the chairman of the Federal Reserve, did yesterday a very brave attempt to ‘start with finishing’ the massive Fed support of the financial markets in the United States and beyond. However, the reaction of sheer panic at the financial markets everywhere over the globe, shows that the financial markets and the general economy are not ready at all for these kind of economic measures.

What in a normal world should be good news (“the patient recovered sufficiently and doesn’t need his drugs anymore”), turned into extremely bad news for the financial markets everywhere. This was exactly the kind of over-reaction that a drug addict shows, when his favorite dealer quits delivering the dope.

May this be a warning signal for all people who think that the interest rates may go up very soon. There is a considerable chance that they won’t and that the current situation at the bond market may continue for a long, long time.

In the coming days, I hope to print more snips from this BNR Newsroom broadcast, including some other questions by Ernst’s Economy for You.However, this depends on the rest of the news in the coming days. 

Nevertheless, everybody who understands Dutch is strongly advised to listen to the integral broadcast of BNR Newsroom, as it was once again a valuable listen.

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