All roads lead to Rome, and low interest rates always lead to bubbles.
It’s hard to know why that’s so difficult for some people to understand.
It seems as though some folks have a problem understanding the concept of ‘cause and effect’.
When you kick a football, it moves (unless it’s full of concrete, but we’ll ignore that possibility).
When you pick up a piece of wood (assuming it’s light enough to lift) the piece of wood rises upwards in your hand.
And when a central bank crunches interest rates to a record low, it always and without question leads to bubbles and muddle-headed investments in the economy.
This was the topic of a conversation I had with one of our researchers yesterday. He was trying to figure out where the next stock market crash would come from.
Would it be oil stocks? What about house prices? Is it in the commodity sector, car loans, or student loans?
All of the above. The next crash won’t be one of those isolated or targeted events that only or mainly affects one part of the economy.
It won’t be something that only affects emerging markets, commodity prices or house prices.
The current bubble is worldwide, and it has infiltrated almost every part of every economy. (We put ‘almost’ in there as a qualifier, on the off chance that there is a part of the economy unaffected by this bubble. But we’re yet to find it.)
Low interest rates have caused bubbles and misallocations of resources and capital everywhere.
The most prominent examples are in commodities. The enormous rally in iron ore and oil prices since 2008 was a direct result of low interest rates (cheap money).
It caused prices to skyrocket. The iron ore price was as high as US$158 in February 2013. Yesterday, it was US$41.90.
The crude oil price spiked to above US$140 in 2008. It was above US$113 per barrel as recently as 2014.
Yesterday, it was trading at US$30.73.
However, here’s an important point. Just because prices of both commodities have slumped, you shouldn’t think the effects of the bubble are over.
We can assure you they are far from over.
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Take this news report from Bloomberg:
‘Kuwait National Petroleum Co. is seeking to borrow $10 billion from local and international banks to upgrade two refineries to produce cleaner burning fuel.
‘Local banks are due to agree next month to lend $3 billion under favourable terms to Kuwait, according to Ahmad Al-Jemaz, a deputy chief executive officer at the state oil refiner. The rest of the $10 billion needed will be sought from international lenders, including from South Korean banks, he said.
‘“We have seen a good response to our request for loans to finance the project,” Al-Jemaz told reporters in Dubai on Monday.’
Whether it’s a direct or an indirect effect of low interest rates, that’s open to question. What can be beyond any doubt is that it’s unlikely that Kuwait would have spent anywhere near US$35 billion on oil and gas projects if it wasn’t for low interest rates.
According to the report, Kuwait will only likely have to pay an interest rate of 4.5% on the loans. Why? The report quotes Naveen Ahmed, analyst at Global Investment House KPSC in Kuwait:
‘“The banks will be jumping at deals like these,” Ahmed said. “These projects are relatively low-risk because they’re being carried out by government-related entities or are public-private partnership projects.’
Ooh. Excuse us. But the idea that a loan to upgrade oil and gas infrastructure is low risk sent a shiver through us not unlike when someone runs their fingernails down a blackboard.
Of the 61 bonds that were on Monday newly considered to be ‘distressed’, at least 12 of those bonds were of energy and resources companies.
There are likely others. We simply looked at the company names. We may have overlooked those companies clever enough not to have either ‘resources’ or ‘energy’ in their name.
But regardless of the industry, something else is clear. While the trend in interest rates may be down, the trend in distressed bond issuers is up.
The chart we have shown you on numerous occasions confirms this — up she goes:
According to this data, at the peak of the financial meltdown in late 2008, there were 761 distressed bond issuers — that is, the number of companies that have bonds trading at non-investment grade level.
(The less kind alternative name for non-investment grade is ‘junk’.)
Today, the number is 576. That’s after more than seven years of an economic [cough] recovery, trillions of dollars in government spending and stimulus, and record low interest rates worldwide.
Only a chump could reasonably suggest that central banks and governments are on the right path by taking interest rates lower and lower.
But wait, what’s this from the newly released minutes from the Reserve Bank of Australia’s February meeting? We quote:
‘The board noted that the outlook for continued low inflation may provide scope for easier monetary policy, should that be appropriate to lend further support to demand.’
That sound you can hear is your editor thumping his bald head against an MDF laminate desk.
Getting back to the point. It’s a mistake to think that bubbles are only about price. Bubbles are about supply and demand too.
The fact that the oil and iron ore prices have soared and then collapsed, doesn’t mean that the period of bubbling has ended.
The effect of the price bubble and the low interest rate bubble will continue. The effects are in the reports of oil gluts at US and international refineries.
Producers are pumping so much out of the ground that the refineries can’t cope with it.
Last November, Reuters reported:
‘A traffic jam of oil tankers has emerged along the U.S. Texas coast this month, a snarl that some traders see as the latest sign of an unyielding global supply glut.’
Oil drillers need to drill.
If they don’t drill, they can’t generate cash flow.
If they can’t generate cash flow, they can’t repay loans or refinance debt.
This is the consequence of low interest rates. Low interest rates drove up commodity prices. They encouraged drillers to drill regardless of the cost.
After all, what does it matter if the cost of production is US$90 per barrel when the oil price was US$140 per barrel? That’s one hefty margin.
And don’t worry about a falling oil price; China’s economic growth will spur demand for years to come.
It sounded half-reasonable at the time. But that’s the problem with bubbles, they always sound half-reasonable. That’s why so many people get caught up in them.
If something sounded dumb and could easily be proven to be dumb, the bubble wouldn’t build.
And so, make no mistake, the bubble continues to build. Regardless of what commodity prices may suggest, the bubble in low interest rates is as big today as it was last month, last year, and five years ago.
That means that, while some folks may think that the recent slump in stock prices (and commodity prices) is a sign that the problem may be coming to an end, the reality is that this bubble is far from over.
It’s worldwide. It’s everywhere. And, unfortunately, it’s only going to get worse before it gets better. But don’t tell the markets that, because going by the action over the past 24 hours, most investors seem to think the recovery is back on track.
Ed Note: This is an edited extract of an article that first appeared in Port Phillip Insider.