The Chair of the Federal Reserve in the United States, Janet Yellen goes before the US Congress in her bi-annual debriefing and tells the members of the august house, the US economy is strong enough to start increasing interest rates.
And the markets do not react violently like May last year when former Chair, Dr Ben Bernanke only gave a hint of rising rates, somewhere far in the future.
It is a matter of opinion whether the US economy is doing well. There are as many doom analysts as there are proponents of a revival. But regardless what your take on US economic performance is, interest rates have to “normalise” at some point. One thing every analysts agrees on is that a zero interest rate policy can not be maintained ad infinitum. This is underscored by one demographic fundamental, the rate at which so-called baby boomers are retiring, and the demands this place on fixed-income investments to provide an adequate return for those retirees to live on.
It is common knowledge that a zero interest rate environment puts fixed income funds under pressure. Even on our local shores, many pensioners are battling because annual returns on pension fund investments are typically less than 5%. Imagine then the impact of zero interest rates.
It is rather irrelevant from which angle one approaches the problem, the outcome remains the same. Short term interest rates in the United States, Europe and Japan, will have to rise to slowly start normalising the enormous market distortions that have come about over a six-year period. But normalising the curve, in turn creates its own unique set of problems, of which the two most important are the draining of liquidity, and the strengthening of the US dollar, the Euro, and the Yen.
Given current developments in Europe, it is doubtful that countries in the Euro Zone will be exposed soon to rising interest rates although it must be remembered, the European Central Bank did raise rates fractionally early in the year. But that did not change the fact that in most jurisdictions, fixed income returns still remain dismal. It must also be remembered that both New Zeeland and Sweden tried to raise rates and then encountered a host of problems.
However, for us here at the southern tip of the continent, all this to and fro over interest rates, is more than just a theoretical exercise. We need to keep a close watch on interest rate developments in the global markets because it is paramount that we stay ahead of the curve. If we don’t, considering our appalling productivity levels, our currencies will simply bleed away as the capital leaves local markets to chase those tiny returns in the big markets.
This simple line of reasoning, coupled with the Fed Chair’s confirmation earlier in the week, leads me to the conclusion that we shall probably see rising rates for the next 24 months. The US economy needs to catch up roughly on some 2% forfeited interest income, and since the low rates have been with us for six years, it is not inconceivable that the neutralisation phase will also take six years. It means we have to be prepared for a prolonged period of rising rates, although the local adjustments will also be very small and paced. Everything depends on the tempo applied in the United States.
If we manage to improve productivity dramatically over six years, then perhaps we can base the strength of our own currencies on our own competitive ability, but I doubt that will happen. I foresee productivity to keep going down, at least for a decade, before any hope of improvement. This spells out clearly that South African and domestic short-term interest rates will continue to rise, albeit very slowly, to maintain the spread and to keep enticing foreign investment to the continent, especially to the Johannesburg Securities Exchange.
A Deutsche Bank report released earlier in the week ranks the probability of a rate increase in South Africa next week as 50/50. In simple terms, this means the pros are balanced by the cons for an increase, and it will probably eventually be decided by Monetary Policy Committee vote, but the vote will not be unanimous.
For the next two years, I think it is a given that we are facing higher interest rates. It is however not possible to state how fast and by what increments. This will be determined by what happens in New York, London and Frankfurt, and sadly not by what transpires in Windhoek or Johannesburg.