Real rates go up as trillions poured down the hole
Deleveraging and saving is not what central banks want you to do.
Last week I wrote about the real story in the U.S. not being the 33% GDP collapse, but the 25% savings to disposable household income rocket ship.
People are receiving welfare, worried about their jobs, and some are taking control in some small way by investing in secondary markets to make some extra cash and rebuild disappearing employment cash flows.
I’ve also been watching commercial and industrial borrowing in the U.S., which is markedly down subsequent to the CARES Act being brought into being. There are some charts below on this point.
So, if lots of people save to rebuild their personal balance sheet by paying down debt, it means they’re not borrowing and investing in primary assets (only in secondary markets) and that causes asset inflation, consumer price disinflation, and if it bites hard it turns into deflation.
In turn, real interest rates rise and that makes fixed dollar debt repayments even harder.
Clearly not everyone will be able to do this, but guess what - the trend is starting and even here in Australia we are visiting that scenario right now, but hopefully not for long.
Here, the real interest rate shot up to 1.65% - this was based on a nominal rate of 0.25% (reaffirmed yesterday by the RBA) and deflation of -1.9% for the quarter. Even if you exclude Scott Morrison’s childcare subsidy and automotive fuels, we deflated by -0.1% and with the Melbourne lock down we can expect more.
The vision of an extended period of disinflation leading to deflation (i.e., 1929 to 1939) is why central bankers continue with QE Infinity in the desperate hope that they can create a borrowing/business reinvestment environment.
But QE Infinity won’t work, just look at Japan. It’s an experiment. If it was working and if the Fed, for example, was convinced it was just a matter of time, Guarantee Infinity would not have been offered.
The answer is to fix the fiscal and drop money down chimneys in the interim while it’s being fixed, in order to give businesses the time to rebuild GDP.
The decade before the Great Depression was categorised by disinflation (similar to the post-GFC period) and then a decade of deflation between 1930 and 1939 with some very bad years between 1930 to 1933.
Inflation only went positive as a result of WWII and I’m pretty sure we don’t want to go there again.
But while central bankers are trying to revive the economy with QE Infinity (and a backstop Guarantee Infinity), the strategy is actually counter to families and small businesses that are seeking to deleverage, save, and in time repair balance sheets as a result of the pandemic.
Those people may not want to borrow for some time, and a drop in borrowing means a drop in investment, a drop in GDP, and no reflation for some time. Monetary policy may be at end game.
Below are some charts that might indicate the beginnings of that trend. Hope I’m wrong.
Stampeding into savings.
We can see from the following chart that the savings rate has gone straight up like a Falcon Heavy rocket, as mentioned last week.
Consumer savings rates are 25.7% of disposable income, the highest in FRED recorded data history.
And, industrial and commercial loans in June dropped by the largest percentage (51%) in FRED reported data history - here’s the 75 year chart.
Here’s a close up of the 51% drop in loans across all commercial and industrial banks.
On top of this, of the $650 billion in loans approved under the Paycheck Protection Program (PPP) only $490 billion was taken up, and $30 billion of that was returned. This caused the program to be extended.
So, we now have a decrease in private sector borrowing and investment, an increase in savings, and a massive drop in GDP as a result of the pandemic response i.e., lock downs, distancing and supply chain disruptions.
In the absence of business building GDP, the sovereign needs to step in.
Is the greatest lesson of the pandemic really sinking in?
Cash is king. If you have a lot of debt and you don’t have savings or cash flow, you are reliant on government handouts to get through a pandemic or some other event that kills off your cash flow.
If this lesson is actually being learned, then like after 1929 (even though for different reasons) there will be a lot of people that will not want to borrow again for some time, and they will spend years rebuilding their personal balance sheets.
If this plays out, those funds will not go into the real economy and the recession will turn into a deflationary depression, or a bizarre form of asset stagflation.
So, the reality is that the world needs more welfare in the interim while governments fix the fiscal.
Central banks cannot fix the fiscal, and so far governments have found it easier to rely on their central banks.
And where to for our direct shipping Banana Republic?
Australia will not be immune to similar secular trends.
A strategy of sending money down chimneys while we divert funds to fix the fiscal is a better way to go (than more bond buying) even down under.
Here, the fiscal broke in Australia in the 1970s, even before Abba was a thing. At that time, a value-added industry to accompany primary industry in terms of hard and soft commodities was ignored in favour of instant export revenues from direct shipping commodities. This and similar short term thinking led to Paul Keating’s famous banana republic comment in 1990.
If we in Australia are to be more than a quarry, shearing shed and food bowl for others, we need to vote into power sufficient political will to fix the fiscal lever, and recalibrate the cost (and competitive) base that rusted over in the 70s.
So far, neither major party has demonstrated an ability or willingness to do this.
From Bananas to Nation 4.0 Terraforming.
Here, our fix is to add value to our primary industries by creating a viable Nation 4.0 weighted downstream processing and manufacturing industry – that’s where I’d like to see the Government and Future Fund invest.
Spend and re-skill before it’s too late. Stop the reliance on direct shipping of non-value add crack n’ stack and other natural resources; value up and broaden our intermediate and end-product offerings and customer base to the rest of the world. Over-invest in education and re-skilling. Get rid of coal and decide between renewables and nuclear. Increase royalties, sort out our lopsided tax system and provide big fat tax breaks for investing in Nation 4.0 transformation, and make it accessible to all societal groups.
Yep, a diverse, inclusive and rock star great southern land transformed by innovation.
A Government and Future Fund financed Nation 4.0 is where Australia should be headed.
That’s what I’ll be thinking about at the next election.
In the meantime, yesterday’s decision by the RBA to recommence bond buying is likely to influence down interest rates, but if the government doesn’t fix the fiscal and we continue to deflate, the increase in the real rate of interest will simply encourage more and more Australians to save, hoard and contrary to what we all want, stall the recovery.
Stay tuned.
Mike.
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