Ed Note: One of Michael Campbell’s favorites, Donald Coxe has 35 years of institutional investing and money management experience in the United States and Canada, and a unique background in North American and global capital markets.

The Highs and Lows of Zero Rates

Zero is a seemingly small number, but it is demonstrating its power to change the world. We have seen many examples in individual countries of The Power of One: this is that kind of power on global scale. We are regularly told that we should expect a roaring recovery Reagan-style.

But if Reagan were alive, and Margaret Thatcher were in good health, they would be astounded at how their two nations’ economies are struggling at a time of zero interest rates—when they had to launch recoveries at a time of record-high rates. (Ed Note: 18% Fed Funds)

The US and British economies are performing at roughly the level they were during the late stages of the 1981-82 recession—when corporations’ and consumers borrowing costs’ were infinitely higher. That inflation could be in the zero range would also astonish them, even though the biggest factor in their first election victories was the runaway inflation of the Carter and Callaghan era—when “malaise” was the Presidential euphemism for the spreading despair.

So why shouldn’t the economic recovery be at least as strong as Reagan’s—if not even more robust? It’s because those Zero rates tell us that the financial system’s problems that triggered the economic collapse aren’t going away quickly—and could even be getting worse.

Reagan and Thatcher didn’t have to deal with serious demographic problems that meant housing prices could not—for the first time since World War II—leap in response to plunging interest rates. Reagan and Thatcher didn’t have to mortgage their nations’s futures to bail out bad banks, which, upon being rescued, diverted the succor they were given to rebuild their devastated capital to speculation and bonuses, thereby making their saviors—politicians and taxpayers—look like suckers.

Nor did they have to face the certainty that interest rates and inflation would have to go up sometime—and that could be very inconvenient for both the politicians and the economic recovery.

US interest rates and inflation could remain at current levels, were America to mimic Japan’s experience from 1990 to Koizumi’s election. But those early years of Japan’s Triple Waterfall Crash occurred at a time of rapid global growth that meant Japan’s trade surpluses grew robustly, and the immense levels of domestic savings were adequate to fi nance Tokyo’s endless fiscal deficits. (Currently, Japanese investors are not quite able to absorb all the debt coming from record deficits, but they’re certainly embarrassing their American counterparts: they’re absorbing 94% of new government debt offerings.) In contrast, America’s trade deficits are a permanent feature of the US economy, and even the current uptick in US household savings is no match for the fast-growing fl ow of new Treasurys, which means the US becomes more dependent on foreign bond-buyers by the month.

The Administration’s forecast through 2019 assumes that foreign creditors’ appetites for Treasurys will grow at least as fast as the national debt. It predicts sustained real GDP growth of 3% per year, with no recessions, no increases in taxpayer cost for health care, and—despite sustained defi cits and a doubling of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from 41% to 82%—long Treasury yields will not rise more than 1%. (We spoke at a Canadian fi nancial conference last month at which Niall Ferguson was the star. He flashed that forecast up on the screen and said, “Those aren’t real forecasts: they’re Mickey Mouse numbers.”)

Despite the current deficit of 12% of GDP, and despite increasing grumbling about Washington’s willingness to incur huge defi cits in bad times and good, the foreign support of the dollar by buying Treasurys continues. There has been one little-remarked change in the investment strategy of America’s Sugar Daddy #1: in recent months, China has been rolling over its maturing Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%–3.4% in favor of near-Zero yields. What power, one wonders, does Beijing think, comes from a Zero return in a weakening currency? And why is that putative power growing so relentlessly?

Published by Coxe Advisors LLC
Distributed by BMO Capital Markets

Basic Points
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