Central banks get sucked into financial black hole

LONDON, Oct. 14 (Reuters Breakingviews) – “In physics, escape velocity refers to the speed required to escape the gravitational pull of a planet.” by Governor of the Bank of England. Mark Carney argued that a super-easy currency would lift the UK economy out of its post-crisis stupor. It never happened. Instead, as Carney’s successor Andrew Bailey discovers, the central bank’s zero interest rate policy is a black hole, a giant dead star whose gravity is so strong that its power You cannot escape from

Central banks around the world want to keep inflation down by returning interest rates to ‘normal’ levels. The BoE’s current tax rate of 2.25% is just over a third of the post-war average level. Despite jumping to about 4.5% this year, 10-year Treasury yields are still more than 5% below current inflation. But the UK economy and financial system are beginning to collapse. To understand why, consider household, government, and corporate exposures.

British people like to groan about super expensive homes. Homebuyers responded to the availability of cheap loans by taking on more debt, and as a result, according to housing analyst Neil Hudson, the average UK mortgage In the early 1980s he increased from 1.5x to 3.4x.

This was acceptable given last year’s mortgage interest rate was about 2%. However, many homeowners are highly vulnerable to rising interest rates. Earlier this month, the cost of a two-year fixed-rate mortgage jumped to 6%. About 1.5 million of these loans will be reset at higher interest rates over the next 12 months. Hudson estimates that UK house prices may need to fall by more than a third to bring them back to affordability.

The UK government is in a similar predicament. The pandemic lockdown has created the largest peacetime budget deficit ever. The state financed the shortfall at the lowest borrowing costs since the Bank of England began its business in 1694. Since 2007, Britain’s national debt has risen from his 34% of GDP to his 95%. However, the government’s debt service as a share of tax revenue fell by almost half. The state’s loan repayment rate fell to her 1.1% last year, down from her 5.8% before the 2008 global financial crisis.

BoE reached out to help. The old lady from Threadneedle Street not only slashed the policy rate to near zero, she also bought a ton of UK government debt through the quantitative easing programme. It still holds around £840 billion. Gold and silver yields have fallen, reducing the cost of new debt. The BoE also remitted interest payments it received on its bond holdings to the Treasury, but last year charged just 10 basis points for a huge loan to the government.

Central banks tend to view quantitative easing as monetary manipulation. However, from a financial perspective, fixed rate debt should be exchanged for variable rate debt. According to a Senate report released last year, the BoE’s security purchases have cut the effective average maturity of UK government debt from nearly 15 years in 2007 to just over 10 years. As a result, the government’s fiscal position is susceptible to interest rate fluctuations. “Lower short-term interest rates are more quickly reflected in government borrowing costs,” concluded the Rhodes Commission, whose members include former Bank of England Governor Mervyn King.

The UK Budget Responsibility Office estimated last year that a one percentage point rise in interest rates would raise the cost of servicing government debt by nearly 1% of GDP. If the UK government were to borrow at its historical average rate of 6%, the cost of servicing the debt would consume about 16% of tax revenue, more than five times last year’s levels.

Corporate debt is also soaring around the world. The level of UK non-financial corporate debt (as a percentage of GDP) has fallen slightly since 2008, while US companies are heavily indebted. According to Bank for International Settlements, US business credit now accounts for over 80% of GDP, up 15 percentage points from 2008. However, debt servicing costs for American companies declined during this period.

The quality of US corporate bonds has also deteriorated significantly. About half of investment grade corporate bonds are now rated triple B, one rank above junk. According to Bain, the private equity firm completed his more than $1 trillion deal last year and the acquisition of a publicly traded U.S. company reached a record earnings multiple. Some buyouts are financed by leveraged loans whose interest payments are linked to short-term interest rates.

Until recently, investors had an almost limitless appetite for such debt. Low risk-free interest rates pushed savings out of banks and into the high-yield credit market. Since 2007, he has had nearly $3 trillion in inflows to U.S. credit funds. The prospect of an unexpected monetary tightening and recession poses challenges, especially for credit funds that have to sell assets when investors are bailed out. Investment strategist Gerald Minack fears market volatility will rise as corporate defaults accelerate, saying: “When there are more buyers, liquidity tends to be higher, but when there are more sellers, it tends to be more liquid. No, especially not in the credits.” The recent turmoil in the UK singles market has led some UK property funds to limit investor redemptions.

Since 2008, advanced economies have not achieved the escape velocity necessary to allow central banks to normalize monetary policy. Clearly, interest rates cannot return to historic levels without crashing home prices, undermining government finances, and roiling credit markets. Not only has the Bank of England failed to raise interest rates in line with inflation, it has repeatedly stepped in to support markets. When a financial black hole opens, central banks will be forced to stop tightening. The ‘pivot’ investors have been waiting for is approaching.

follow @Breakingviews on Twitter

contextual news

Edward Chancellor is the author of The Price of Time: The Real Story of Interest.

Edited by Peter Thal Larsen and Oliver Taslic

Our standards: Thomson Reuters Trust Principles.

Opinions expressed are those of the author. They do not reflect Reuters News’ commitment to integrity, independence and freedom from bias under its Trust Principles.