Brent Sheather: Financial repression coming our way?

It appears we have entered an era of return-free risk. Photo / Thinkstock

It is getting harder to make a living without actually working. These are not good times for the idle rich or the retired living off their savings. If you look around the world short term interest rates are well below inflation in most developed countries.

Even investing for 10 years doesn't get you a real return in the US, UK or Germany. In the US investors have to go out 30 years to get an interest rate that is above the long term rate of inflation. This isn't the normal state of affairs - since 1900 short dated government bonds around the world have provided a 1.0 per cent return above inflation according to the Global Investment Returns Yearbook.

What's happening here?

It appears we have entered a new era of "return free" risk. This environment has been labelled "financial repression" and it has ostensibly occurred because the central banks of the world are printing money and using this money to buy long term bonds, thus keeping interest rates lower than they would otherwise be.

See a chart of New Zealand's Ten Year Bond Yield less inflation here.

This sounds simple enough but it is right to be sceptical of such a simplistic argument. Markets are supposed to be reasonably efficient so perhaps interest rates are low because the outlook for the world economy is bad. Countering this view however is the level of the world stockmarket which is trading at elevated levels based on longer term valuations. Low interest rates imply bad times are coming but high stockmarkets suggest that good times are coming so both markets can't be right. We will have to wait another 10 years to find out which market is correct.

But we have become side tracked - this story is about financial repression and it is one of the biggest issues facing investors today because it is not a painless exercise - someone pays and it might be you, dear reader.

Financial repression is attractive to governments because it is the least painful solution to the problem that they have of having borrowed too much in the past. They know that if they can keep their borrowing costs down and engineer a moderate level of inflation the real value of government debt will fall and the all important figure of debt as a percentage of GDP will gradually move down from the current dangerous levels.

The savers of the world are paying as even if they pay no tax and don't spend their income the value of their savings is not going to keep up with inflation. The alternative is austerity or, if interest rates are allowed to rise with inflation, the possibility of default. The PIGS of Europe (Portugal, Italy, Greece and Spain) don't appear to have the option of financial repression so they are being forced into "austerity" and the possibility of widespread social disorder.

Edward Chancellor from investment manager, GMO, recently wrote about the repressive fixed interest environment that existed in the US after the second World War. At that time the US imposed caps on short term bank deposit rates and held interest rates generally well below the level of inflation.

Mr Chancellor quotes a paper by an academic which estimates that negative real interest rates provided a subsidy for the US government equivalent to a massive 2.3 per cent of GDP a year between 1945 and 1980. No surprises that the ratio of US government debt to GDP fell from 116 per cent to 32 per cent over that period.

But we are lucky because we live in NZ and Australia is right next door. NZ and Australia stand out as two of the few western countries with relatively low levels of government debt, reasonably balanced budgets and, best of all, interest rates that are above inflation. Investors in other Western countries must look enviously at our real interest rates. Indeed NZ and Australian bonds got a mention in one of the world's biggest fund manager's quarterly reports last week.

So we can probably expect a continued flow of overseas money into our bond market. The question before the panel therefore is "how much longer is this happy situation going to last?" Just last week ten year Australian government bonds hit an all-time low of 3.54 per cent, in both NZ and Australia the central banks are now alluding to cuts in short term interest rates and, most ominous of all, John Key seems to be smiling even more than usual.

So what could a repressive scenario mean for local investors?

They say the trend is your friend and the downward trend of interest rates, from a retired individual's perspective, is frightening - five years ago a six month bank deposit returned 7.20 per cent and today that figure is 4.30 per cent. For someone relying on the interest that's a 40 per cent drop in their income. If however NZ's rates continue to converge with those of the US etc. short term rates could fall a lot further. A 2.0 per cent deposit rate would mean a 72 per cent fall in interest income. Most long term forecasts of NZ inflation are in the 2-3 per cent range so a 2 per cent deposit rate would be a negative real rate of return. Couldn't happen here you think - it has happened before.

According to the Global Investment Returns Yearbook (GIRY) in the 50 year period between 1940 and 1990 the real return on both short and long term government bonds was negative. But hold on, it gets worse. If we focus on the 1970s we see that this was a particularly bad time to be a bond investor. According to the GIRY in the 1970s inflation averaged around 10 per cent pa, but bond returns were just 2.5 per cent pa.

What this meant was that in the decade ending 31 December 1979 NZ government bond investors lost almost half their money in real terms. A disaster. That repressive environment for bonds was chiefly authored by NZ's most famous economic anarchist, the one and only (thank god) Sir Robert Muldoon. Inflation in NZ was high due in part to the oil crisis but government bond yields were suppressed by the government thus giving rise to the period of negative real yields readily apparent in the graph.

If we are indeed heading for another period of financial repression and interest rates do move lower this will require different investment strategies to what we have been used to. However anything is possible.

A repressive strategy requires relatively low levels of inflation and interest rates below this level but inflation could get out of control and if this happened the downward trend in interest rates would quickly reverse so that investors with portfolios biased to accommodate a repressive environment would suffer big losses.

Nothing is simple in this game.