Chaos Calm or Cheer

Although, there are a lot of questions in the minds of the debt investors – like how is the debt market going to perform in the coming 6 months to 12 months, being rallying for almost 30 years, will the interest rates remain low or will there be any sharp reshaped turn back.

The market experts say that while reviewing the global economy, the coming 6 to 12 months seem to be positive but anaemic, the investors should not be worried about the downturn prevailing in India as well as globally. The experts also say that, although the interest rates may stay low it doesn’t mean that we are not going to have an easy ride because the market reacts more violently to news and there is going to be more volatility and confusions in the risk markets.

To substantiate the above let’s have a deeper look into this.

Global and the market outlook

The preservation of low interest rates is crucial to preserve macroeconomic order. It seems that the global growth has dropped dismally which was supported by the bottoming of global GDP and the PMI (both Services as well as manufacturing). The drop during late 2018 through 2019 has been significantly driven by manufacturing.

But, in the recent time we can see cyclical bounce back around in the global economy, the reasons being  significant easing by the federal reserves, accommodative stance from the central banks around the world and the steps put forward by China to stimulate its economy. All these steps are taken on the monetary side, on the Fiscal side, most of the countries except Europe are loosening its policies along with the easing of trade agreements between the countries may influence in the global economic growth pick up.

The factors that influence the global debt market:

Trade growth

For the last ten years, we have seen an anaemic growth in trade. The global economic growth that came after 2008 was quite weak due to the fall in the export volume. This was majorly due to the lower import in Europe, which went through a major crisis after global financial crisis. The growth rates in Europe were basically flat during 2011 to 2015, so there was a big drop in imports coming from China to Europe which influenced this fall. The exports contribute more strongly when the economy is growing, this was clearly visible during 2000 and 2010 when the economy was growing, the exports were growing on 5 – 10% yearly. But the average growth in the recent 5 or 6 years were limited to 2 – 3%. In recent times, policy makers have turned their attention more towards domestic considerations which will create opportunities for countries like India where lower labour cost brings some advantage.

Global inflation

The global inflation has been steady between 2 and 3% in the recent years and that is one of the enablers that keeps the fixed in come yield to stay low.

Central banks

The central banks play an important role in the global fixed income markets. They turn the market through overall asset purchases and overall level of asset it holds. It also plays an important role by injecting liquidity into the market which maintain the interest rate. In the recent times, the central banks have expanded their balance sheets dramatically and are again easing its norms.

All these are likely to support the fixed income market in the coming years.

The fundamental drivers behind lower yields are:

Excessive global debt

The paradoxical idea is that high level of debt actually leads to low yields. How it works is – when there is a high supply of something, the price goes down, so when prices of bonds drop, the interest rates associated with it should go up, not down. The reason is that the bonds are not isolated commodities, they are intimately connected with how the world works. When you have high levels of debt, that is a big drag on growth, and it is a big drag on inflation and these two factors together pull down the yields.

There is another aspect to this – when you get into certain level of debt, everybody, except the investor, keeps pushing the interest rate low. So, policymakers then join them and keep the interest rates down.

Since the global financial crisis, the overall debt continues to go up, whereas, there was a steep rise in the government debt while the private debt has been flattened after the crisis. When the countries get richer, the level of non-financial debt tends to increase. So, when more and more countries climb the ladder, we should expect that there will be an increase of debt along with this.

The governments usually create the debt through Fiscal deficits. Around the world, as monetary policies become less and less effective due to interest rates close to zero, the governments moves more in to Fiscal policies. Indian is not an exception.

Aging Demographics

The aging demographics of the world plays an important role in lowering the interest rate. The working age population around the world is dropping down for some time. The average working-age population of China, the production hub, is leading this drop, and this is going to continue for the next 10 to 15 years. Now, how does the dropping age influence the interest rates.  In recent times, Japan and Europe showed us that the aging population accompanied by slow growth and less inflation and lower interest rates.

So, when the economy became unequal, the demand side of the equation dominates and it keeps the prices under control and its takes away the ability of the wage earners to demand high wages. This is aided with globalisation, technology and automation. So, whatever demand exists in the economy can be met with the same number of workers without paying more.

Inequality

In addition to aging, there is also the inequality of wealth among people which increased in last 20 years to 30 years plays a major role in pulling this interest rates.

So, what happens when the wealth concentrates only on a small population, say, 10% of the people.

Well, these are the people who do not spend their money and thus consumption does not increase. The people who would spend the money they get belongs to the other 90%, but the money does not reach them. So even though the economy has a decent growth rate, the consumption does not increase.

Tax structures

In the earlier times, the tax rates used to be higher not only in one country or two, but also in almost all countries in the developed economy. Since then the corporate taxes have come down dramatically across the world. What is the connection between corporate tax and interest rates? The connection is that when you have a high tax rate and have deductibility of interest income, then increase in interest rates are tolerable. As most of them gets written off in other words on an after-tax basis the impact of higher interest rates is diluted and then when you get tax rates below 50% then the interest rate increase are very sensitive, they really hurt your profitability.

Conclusion

The economy has seen 30 years of dropping interest rates, we have seen it through rising and falling cycles of economic growth, lower lows and lower highs in interest rates throughout. Yet, there are some countries which are creating worries, where you have negative interest rates, in other words to lend your money for 10 years you must pay some amount. This will have really bad effect in the banking systems of this countries. So, this gives an outlook that the long-term interest rates are going to remain low for several coming years.

Ranjith
Dilzer Consultants Pvt Ltd