Low rates for … shorter?

The consensus is that interest rates will stay ‘low for longer’, particularly in Australia. But what if this view is wrong?

Christopher Joye – the best journalist at the Australian Financial Review, in my opinion – penned another gem in last weekend’s issue. For those who don’t have an AFR subscription, Joye’s column questioned the current consensus that interest rates will remain low for longer. The money quote:

‘Pretty much every sophisticated investor I’ve spoken to over the past 12 months has embraced the ‘low rates for long’ paradigm. It makes for a conveniently benign world view….[y]et it is as intellectually lazy as the fallacious 1990s and 2000s fads that sparked the tech boom and leveraged finance bubbles’.

The ‘low rates for long’ paradigm argues that deleveraging by highly-indebted economies will keep economic growth low for a number of years, potentially creating deflation and also keeping interest rates at very low levels. Joye disagrees, suggesting that the self-interest of politicians will lead them to encourage inflation – with the much appreciated assistance of their central banks’ attempts to avoid deflation – thus eroding the real value of their country’s debt burden rather than risking unpopularity by reining in spending and repaying debt.

In support of this view, last night’s Budget is Exhibit A. After its relatively mild efforts to rein in Australia’s budget deficit last year were met with a large decline in popularity, the government has dramatically changed tack in a desperate attempt to claw back lost votes. For even more aggressive attempts to avoid reducing national debt, look no further than the current Greek government.

The other evidence supporting Joye’s argument is recent indications that wage pressure might finally be picking up in the US, suggesting deflation may not occur after all. Combined with an uptick in inflation in Europe earlier this month, this led to bond prices of countries including the US, Germany and Australia plunging.

As this shows, Australia is unlikely to be protected from any normalisation of US interest rates, despite the end of the mining boom and continued subdued business investment. This is because most of our government bonds are purchased by foreigners and, as Joye also points out, Australia’s three and 10-year bond yields are more than 90% correlated with equivalent US rates.

So if this view is correct, what should you do? Joye suggests investing in cash, floating-rate notes and gold (as protection against inflation). For our part, we’d suggest reducing your exposure to stocks that have become expensive due to the search for yield, such as the Commonwealth Bank (ASX: CBA) and ANZ (ASX: ANZ), Telstra (ASX: TLS) and most A-REITs.

One of the things that separates good investors from the rest is that they think for themselves and always question the prevailing consensus. We freely admit that our view could be wrong but if it is, those who agree with us won’t lose much money. If we’re correct, however, substantial future losses may be avoided.

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