The trap opens wide

Israeli readers of this column will know that their central bank, the Bank of Israel, cut interest rates this week. Its Monetary Committee, in its monthly meeting, decided to bring the bank’s lending rate down by 25 basis points – one-quarter of a percent, in normal language – to 0.75% per annum. Almost every forecaster was caught by surprise by the timing of this move, if not in its content. But more importantly, the analytical response was dominated by head-scratching and looks of puzzlement: what was the purpose of this move and what good would it do?

I am not going to waste a column trying to answer that question, mainly because it doesn’t make any difference. The essential point is that interest rates in Israel are almost at their historic low-point of 2009, although this time there is no overt global crisis raging. On the contrary, the grand pretence of the central banks and the governments of the developed economies is that the global economy is recovering. The truth is that it is doing nothing of the sort, it is merely twitching under the massive stimuli that said central banks are administering to their national economies. If you want to know what would happen if the stimuli were withdrawn, just observe the ongoing ructions in China or, worse, the dreadful state of several leading emerging economies – yesteryear’s darlings – where the foreign hot money has rushed out and left these countries in all kinds of trouble: financial, economic, social and political.

Fortunately, the Israeli economy is in fairly good shape, even in absolute terms, whilst relative to the large emerging-market economies it is in excellent condition. But that will not prevent it from suffering severe stress when interest rates rise – as they will, sooner or later. Indeed, because interest rates have been pushed so low and held down for so long, it is reasonable to expect that when the reversal comes, it will be both sharp and large – meaning that interest rates will rise a lot in a short period of time. Again, if you want to see live examples of how that happens and what it does to economies, firms and households, please review recent developments in India, Turkey, Brazil and elsewhere.

All this is clear enough, unless you believe that the current distorted state of the global economy can continue forever. Absent that delusion, it is incumbent upon every thinking person (there aren’t many left, and fewer all the time) to engage in the thought experiment of what would happen to him/ her in that scenario. The general answer is that paper wealth would be sharply reduced, because all assets that are linked to interest rates would fall in value. The sharper the rise in rates, the greater the fall in value. The quicker the rise, the greater the fall. And, in the case of bonds and similar financial instruments, the longer the time until maturity of the bond, the greater the fall.

This is not a prediction, merely a statement of well-known facts, akin to describing the impact of a heatwave on crops and fruits currently growing. These facts are well-known to everyone in the financial services sector. But – and herein lies the big difference between the financial sector and most areas of the physical world – it is much easier to believe that the framework of the financial sector can be structured (read manipulated) to generate a benign and beneficial outcome than is the case in the physical world.

In other words, most people – from housewives to heads of corporations and governments – are able to convince themselves that bad outcomes can and will be prevented from occurring in the financial arena. Furthermore, there is a vast and powerful network of financial institutions which is actively engaged in persuading its customers of that conviction. These customers act upon this brainwashing by, inter alia, borrowing heavily – because interest rates are very low so money is cheap – and also by investing in instruments that offer higher returns than the meagre rates available on standard instruments, such as bank deposits and government bonds.

By doing so, the households and firms doing the borrowing and investing lay themselves open to severe losses, when – not if – interest rates rise. The lower rates go, the more likely they are to rise in the future. At current levels, there is very little room for rate to move down, but enormous scope for them to rise. Of course, it is universally thought unlikely that interest rates will rise soon – and that will continue to be the case, until they do. A month before a sharp rise in Israeli interest rates, no-one will be expecting that to happen – that is the lesson from Turkey, India et al. And, no, Jews are not cleverer…

The low interest rate environment is enticing borrowers to their doom by offering them more money at cheaper prices than ever before, and it is pushing investors to their doom by persuading them that risky investments – especially bonds issued by second and third-rate corporations offering “attractive” rates – are desirable. The Bank of Israel has just made a further modest contribution to the inevitable disaster, regarding which Churchill’s acerbic comment on Atlee is apposite: “Mr Atlee is a modest man – but then Mr. Atlee has much to be modest about.”

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