What if the next interest rate move is down not up!

After the recent set back in equity prices the question arises once again, is this just a correction, or is it something more as concerns grow for the outlook of the global economy? The first thing to remember, bear markets tend to occur post an economic recession, which has been preceded by a period of tightening monetary policy. Policy tightening is normally associated with central banks raising interest rates; falling inflation can have the same effect.

Many comparisons are made between now and the 1930's, indeed we wrote about the similarity between the innovation of electricity in the 1930's and the Internet in the 2000's. Both era's leading to periods of leverage and a subsequent fall in stock prices caused by that leverage.

Today the UK inflation rate fell to its lowest level in 5 years, just 1.2%. Much market sage's expressed the view at the start of these aggressive monetary policies; the result would be a world of rampant inflation. It is becoming abundantly obvious, at least in the foreseeable future that is unlikely to happen, deflation is now becoming the threat.

Back to the 1930’s, deflation took hold, at one stage in 1932 the real interest rate in the United States reached almost 15%, as inflation ran at minus 10 percent and interest rates were over 3%. The real interest is defined as the nominal interest rate minus the rate of inflation. The incentive during that period of time was to hoard cash and not invest it, something the central bankers are loathed to happen today. Interest rates in the UK and US are currently close to zero and inflation is running just above 1%, real interest rates are minus 0.5% a long way from the plus 16% of the mid 1930's. If inflation continues to fall that real rate continues to rise, what the policy makers are clear about is they do not want this to happen. This is why as the inflation rate falls in the Europe close to zero, the ECB have introduced negative rates.

Our conclusion to this is that whilst inflation remains no threat, in fact deflation remains the greater threat, interest rates are not going anywhere fast. Central bankers fear inflation but they fear deflation more particularly in a world saddled with debt. The lack of inflation makes the real return on equities look more attractive, (assuming dividends can be maintained). One could easily make the argument that the next move in UK rates is not up as everyone assumes but down!

Posted on October 14, 2014 .