Each time interest rates begin an upcycle, investors must ask themselves two questions. Who can least afford the higher interest rates, and when exactly do they get into trouble?
Since the 1970s, we’ve had all sorts of borrowers get into trouble each time rates rose. Asian governments, US banks, US mortgage borrowers, European governments, US tech stocks, and so on and so forth.
And each time, the level to which interest rates had to rise to trigger the crisis was a little lower than the last time. And each time, rates had to fall ever lower to reengineer the next bubble.
So, who’s it going to be this time around? Who will trigger another bust-up when their interest bill gets too expensive?
Well, first of all, let’s confirm that rates are going up. And by how much.
At the Bank of England (BoE), which just raised rates to 0.5%, traders are now expecting 1% by May. That sounds piddling, but consider it’s double the current rate, four times the recent rate and ten times the rate which was prevailing before that…
Do you think borrowers can afford their interest bill to double or quadruple?
Bloomberg had some more interesting points to make about the BoE’s move. First of all, “the increase marks the first back-to-back hike since 2004.” The speed, in other words, is unusually fast. But it was almost a lot faster:
Policy makers came within a whisker of delivering a 50-basis point increase, with four of the nine-member opting for an increase that would have been unprecedented since the U.K. central bank gained independence from government in 1997.
Here’s another part of the announcement to take note of:
The move lifted the benchmark lending rate to 0.5% from 0.25%, ushering in a new era where the BOE will start to unwind 895 billion pounds ($1.2 trillion) of bond holdings it amassed over the past decade to stimulate the economy.
This makes things interesting for the government, which must find buyers for its bonds to finance its deficits, now that the BoE will stop buying. But at what price… or bond yield… will those buyers actually show up?
The change suggests that the BoE could lose control of the bond market, which is when interest rates spike above what central bankers have been doing in policy shifts.
Actually, it’s worse than just needing to find bond buyers for fiscal deficits. The government must also find buyers for refinancing its expiring bonds.
Until now, the BoE had been buying government bonds and rolling over its holdings too, meaning that it would buy new bonds as old ones expired. But this is set to end too.
Actually, it gets even worse. The interest bill, too, will need to be borrowed, as rates rise: “The BOE will immediately stop reinvesting the proceeds of expired gilts, allowing more than 200 billion pounds to run off by 2025.”
Actually, it gets worse again. It’s not just government bonds which the central bank has been soaking up: “It [the Bank of England] announced plans to offload the entire 20 billion pound stock of corporate bonds by the end of 2023.”
So, this isn’t just about pegging interest rates under monetary policy. It’s about selling corporate and government bonds, and letting them expire, against the previous situation, in which the bonds had been bought and rolled over.
Who is going to be lending the government and companies the money that used to come from the central bank? At what interest rate?
Well, the BoE is now concerned inflation will top 7%, so what interest rate would you demand to lend to the government or companies at…?
And remember, the Monetary Policy Committee is still WELL behind the curve. The following commentary from Bloomberg probably would’ve given central bankers a heart attack before 2008:
Stressing its inflation-fighting mandate, the BOE said that “the remit is clear the inflation target applies at all times, reflecting the primacy of price stability in the U.K. monetary policy framework.”
BOE officials lifted their forecasts for the peak of inflation to 7.25% in April, more than triple the BOE’s 2% target. Inflation had previously been expected to peak around 6%.
There has been a lot of talk and barely any action, in other words.
A meaningful tightening of monetary policy is miles away. And we may never reach it if someone out there goes bust before then.
The Americans are on the move too. Bloomberg highlights “The U.S. Federal Reserve is expected to unleash its own rapid tightening cycle this year, and there has been speculation that may include a 50-basis-point hike.”
But in the United States, too, the actual rate hike cycle, while multiples of current levels, is still expected to peak at a low level. In fact, traders are expecting “the Fed will end the cycle with the policy rate at about 1.65% and long-term inflation expectations anchored around 2%.” So… real interest rates (interest rates less inflation) will remain negative.
This is, again, absurd given that inflation is at 7%, the highest since 1982, when it took 21% interest rates from the central bank to rein it in…
Over in Europe, the ostriches at the European Central Bank (ECB) have pulled their head out of the sand and realised that inflation is spiralling out of control. “ECB opens door to 2022 rate hike in policy turnaround,” reported Reuters.
Turnaround was putting it politely, too. Until now, the ECB had come up with a teenager’s worth of excuses and denials about the inflation ripping away at the euro area.
Even Reuters piled it on:
The European Central Bank finally acknowledged mounting inflation risks and even opened the door a crack to an interest rate increase this year, marking a remarkable policy turnaround for one of the world’s most dovish central banks.
And the analysts were not very nice either: “The European Central Bank made a remarkable hawkish backward roll,” ING economist Carsten Brzeski said.
Now, ask yourself this: is ECB President Christine Lagarde stupid?
Actually, don’t answer that question.
Ask yourself why central bankers might be willing to let inflation run out of control? Why might they deny that it’s out of control for so long?
Well, debt is easier to repay when it is inflated away…
Central bankers are, in other words, more worried about debt levels and the next debt crisis, than inflation.
But I’d say that we’ve got well beyond that point. The reason that the ECB has been ignoring inflation is far more direct. A lot of European governments aren’t just worried about higher interest rates from the ECB. They need the ECB’s quantitative easing (QE) programme to finance their debts because investors wouldn’t do so at current bond yields.
Going into the pandemic, Italy was in trouble already. And the pandemic gave the ECB the cover it needed to buy up the bonds which Italy needed to finance its deficits.
Now that inflation has finally cornered the ECB, it isn’t interest rate hikes that are on the menu first. It’s a reduction in QE. As Lagarde said, “We will continue to observe the sequence we have agreed and we will be gradual in any determination we make.” And that sequence she’s referring to means cutting QE before raising rates.
So, Europe might not even get to raising interest rates before a sovereign debt crisis kicks off. In fact, euro areas governments may experience a funding crisis just from a lack of QE. Indeed, Italian bond yields have surged on the ECB’s announcements already.
The recent plunge in tech stocks points to the bursting of a bubble that was persisting as recently as October last year. What matters even more – using another metaphor – is that there has already been a lighting of the fuse which will ultimately lead to a financial explosion.
It’s now only a matter of time before someone, specifically someone big, goes bust.
This fear is part of what has kept Nigel Farage and Rob Marstrand so cautious over at UK Independent Wealth. Find out what they are recommending you do here.
Editor, Fortune & Freedom