As central banks cut rates, beware of liquidity traps, says OCBC’s Lee
Adecade of playing vigorous sports, coupled with poor sleeping and working habits, slowly resulted in a slip-disc problem for Howie Lee that required surgery. Similarly, events such as the US-China trade war, Brexit, the unrest in Hong Kong and tepid growth even amid a low interest rate environment in many economies did not occur overnight. Rather, their genesis can be traced to the global financial crisis, says Lee, an economist at Oversea-Chinese Banking Corp, speaking at a recent forum organised by The Edge Singapore.
“The world never recovered from the 2008 crisis,” says Lee, who received a hearty round of applause after disclosing that he had had the operation done just days before the forum. Unfortunately, the world economy is not ready to recover as quickly as Lee did from his surgery. The outlook, he says, is bleak.
US markets are trading at rather lofty levels, but the fundamentals are not exactly justified. The reason, Lee says, is that a gush of money — no thanks to low interest rates — is sloshing around looking for places to invest in the US equity market. The money naturally gravitates towards supporting stock prices.
The US Federal Reserve recognised the problem of too much liquidity generated by a decade’s worth of easing and, with the US economy seemingly healthier, had started raising rates incrementally in 2017 and 2018. Lee notes that, as recently as the Federal Open Market Committee meeting last December, the message was “we are going to ignore the noise and we are going to continue raising interest rates”.
Yet, almost half a year later, rates are being cut again. From a recent peak of 2.5% in June, the federal funds rate is now 1.75%. And economists are now debating how much lower they will go. “Central banks normally don’t change their positions from one meeting to another. It has been a remarkable turnaround, but that also [shows] the kind of stress they are facing right now,” says Lee.
Other central banks are compelled to follow the direction set by the Fed as they try to arrest the slowdowns in their respective economies. Lee lists a string of rate cuts already made by other countries, such as India, Australia, South Korea and Thailand, some of which are already at or near 2008 crisis levels. “What kind of signal are you sending when your interest rate is the same as [during] the 2008 crisis? And if your economy is not as bad as then, yet, with the same rates, how much more can you cut if your economy turns further south?
“The whole macro deceleration has been going on for a year now, and it is already a very mature story. This has been very much reflected in the collapse of bond yields across the world from the US to the EU, right down to Australia and Canada.”
His biggest worry is the “real threat” that “liquidity traps” will form. This refers to a situation in which central banks cut rates in the conventional belief that cheaper credit will stimulate borrowing and spending. Yet, this desired result rarely occurs and economies become stuck in a vicious cycle.
Japan was a prime example of a country in a liquidity trap. It languished in that state for 20 years in the wake of a deflation in the late 1980s, and the economy refused to respond to rounds of stimulus. The eurozone faces the same problem today. “If the US, South Korea and Thailand approach the 0% level, then we have a big problem on our hands,” says Lee.
“What happens in a liquidity trap is that there’s uncertainty in the economy, there’s pessimism and, no matter how much cash you pump into it, no matter how much you cut interest rates, people are still going to hold on to the idea that cash is better. So, overall, interest rates will remain low in the near term, and they are here to stay for a while longer.”
The low point
The way Lee sees it, a new phenomenon in the financial markets is the growing acceptance of negative interest rates. This trend started in Europe and Japan and, Lee says, the “low point” for him is that even Greece has issued negative interest rate bonds.
In effect, Greece is borrowing money from investors, who are paying for the privilege of lending money to it. Almost four years ago, Greece, under then finance minister Yanis Varoufakis, threatened to unravel the entire eurozone monetary system. “Greece was the bad boy of Europe,” says Lee. “That’s a testament to how low interest rates are in the rest of the world.”
So, how could negative interest rates even exist? Lee explains that money is always held in banks for ease of movement. The convenience thus enjoyed is deemed worth the losses that the owners have to bear in a negative interest rate situation — something “unspeakable of and unthinkable 10 years ago, but is today the norm”, he says.
While not all investors will need to go near negative yield bonds, says Lee, certain groups, such as asset managers actively trading the markets, do. “They expect yields to be even more negative in the future. So, if they buy a negative yield bond now and it drops even further, they make a profit out of it.” Or the buyers could be sophisticated investors, borrowing from low (or negative) interest euros and then investing in the US. “Then, there are groups of people who buy negative yields because they think the world is coming to an end. I’m not one of those yet,” quips Lee.
There is another group: those who buy negative yields because they have no choice — for example, pension funds and insurance companies. They are obliged by their respective central banks to maintain certain liquidity ratios and they have to be able to meet clients’ withdrawal demands. “They are there to buy it no matter what the rates are. So, these guys are on the losing end,” says Lee.
More than just suffering from losses instead of earning from interest rates, there are wider concerns as a result of this negative yield phenomenon: Monetary policies are losing their effectiveness and becoming less important versus fiscal policies. The Fed, for one, is entering this slowdown with an “arsenal” already half depleted. Prior to the global financial crisis, rates were at more than 5%, with plenty of room for cuts. The rates are now at just 1.75%, offering much less wiggle room.
“There will be more proponents of what we call the modern monetary theory, where people advocate for governments — instead of the central banks — to take charge. And once the rate hits 0%, the onus will really be on the government; the US Treasury Department will have to think of ways to stimulate the economy via fiscal stimulus, or what we call the Keynesian style of jump-starting the economy,” says Lee.
US recession?
Investors want to know whether the US will slip into a recession next year. The traditional drivers of a recession, such as high inflation, oil supply shock and asset bubbles, are not currently evident. So, for now, the Fed forecasts a growth of 2% in 2020 and then 1.9% in 2021. “So, it is their way of saying there’s no recession on the horizon as yet, although we know that recessions typically catch you on the blind side,” says Lee.
In addition, there is a wild card in the form of US President Donald Trump, who is seeking re-election in 2020. “This gives him an incentive to maintain stability and, by stability, I mean he will not deliberately go into armed conflict with Iran or Turkey, for example. There’s a higher probability that he wants a ‘mini deal’ with China, which has already been concluded in some sense, so that he can boast a win back home, during his electoral campaign,” says Lee.
As for Singapore, he concedes that it was “nerve-wracking” to see the country narrowly avoid dipping into negative territory. In 3Q, GDP grew just 0.1%, and it is “highly unlikely” that there will be a recession in 2019.
He believes that this year will be a trough, and that a gradual pickup will be seen next year. “We have a low base in 2019 and, in 2020, given what we’ve just said about the US economy, the incentive to maintain stability, the higher probability of a US-China trade deal, I think we should regain some footing in our manufacturing scene, especially in the electronics export sector,” he says.
Furthermore, when the government announces its Budget in early 2020, it is expected to introduce “sizeable” measures to help arrest the slowdown. The incentives and measures, while unlikely to be as substantial as the ones introduced during the 2008 crisis, will still be substantial enough to give a few points of growth, says Lee.
On Nov 9, after Lee gave his presentation, Deputy Prime Minister Heng Swee Keat announced that the government would offer additional support for Singaporeans in the coming budget, ahead of hikes in the goods and services tax. Nevertheless, economic growth remains fragile. “You might see a big bump-up in the 2020 forecast, but it is by no means anything that is comforting at this point,” he warns. E