The Challenge of a Low Interest Rate Environment

In 2001 when G.W. Bush was sworn into office, interest rates were 6.6%. The dot com bubble had popped in 2000 and the economy encountered a short recession. In response to the recession, then Federal Reserve Chairman Alan Greenspan began to cut interest rates to spur economic growth. 

The rate cuts of early 2001 were an effective central bank policy and were working to spur consumer demand, but the black swan event of September 11, 2001 changed the economic paradigm. To address the major economic impact of the terrorist attack, the Federal Reserve continued a policy of lowering interest rates. This policy was important: after 9/11 the United States invaded Afghanistan, in March 2003 it invaded Iraq. The combined cost of these wars was immense, and the Republican-led Congress determined that the economic recovery could not be sustained with tax increases - thus a period of deficit financing began.

Debt-financed wars are not uncommon, but with deficits entering the hundreds of billions, the Federal Reserve had to act to ensure that interest payments on the debt would not be crippling to the US federal budget.

There are long-term impacts to the large amount of debt brought on my the Bush tax cuts and the wars in Iraq and Afghanistan. By 2019, the legacy of those policy decisions will account for nearly half of public debt.

As a result of this massive increase in public indebtedness, the Federal Reserve under Greenspan continued to cut interest rates to assist in financing the tax cuts and wars. This is standard central bank policy dating back to World War I. The interest payments on a low interest rate vs. a nominal interest rate can save billions for the government.

Unintended Consequences

This policy, while prudent, created "externalities". This low rate environment that the Fed perpetuated created a correlated low rate environment in the mortgage market. Between 2001 and 2007 interest rates declined substantially, increasing home affordability and creating increased demand for housing.

Overall, this would be considered a good thing, but President Bush created a problem for central bank policy when he began began promoting the "ownership society". Bush policy fomented the bubble because in a period of historically low interest rates, home affordability was already producing a hyper-cyclical growth rate in house appreciation. Between 2001-2005, the economy and home price increases were actually within historical norms, it was only the creation of the subprime market, as a result of regulatory changes, that in 2005-2007 that created the bubble, which resulted in the crash, credit crunch and financial crisis of 2008.

Global Externalities

This US low-rate environment created challenges for other central banks. The Bank of Canada, the European Central Bank, the Bank of Japan, all cut interest rates in correlation with US monetary policy. They had to. If they had not, US dollar inflation would have increased the price of Canadian, European and Japanese exports. This created a "race-to-the-bottom" with interest rates that have fueled global bubbles. Hot money flowed into emerging markets and the BRIC countries (Brazil, Russia, India, China) saw extraordinary growth between 2002-2012. This hot money also flowed into global housing markets. China, Canada and the Netherlands being the most prominent bubbles.

The Canada Conundrum

In Canada specifically home pricing have increased dramatically as a result of the increased affordability granted by low interest rates as well as hot money inflows from the US, China and Europe.

From 2000-2012 Canadian home prices more than doubled. The average Canadian residential property in 2000 was $152,000. In a decade that home has ballooned to over $350,000 and the growth continues at ~5%/yr.

This makes sense from an affordability standpoint.

For example in 2000, a $150,000 mortgage at 7.2%, cost $1235/mo. in mortgage and interest financing.

In 2012, at $350,000 mortgage at 2.87% cost only $2000/mo. in mortgage and interest. In effect, while the value of the asset increased 200% between 2000-2012, the cost of owning the asset grew at a much slower pace, 62%.

This low interest rate environment is creating bubbles in many markets, but none so obvious as housing. This is a very troubling asset class to have a bubble, because unlike the dot com bubble, this bubble hits consumers most, not speculators. In addition, houses are often used as retirement savings accounts and so any decrease in value can have very deleterious effects on wealth.

The Turn

A low interest rate environment is likely to persist for the foreseeable future. The Bank of Japan is using negative interest rates as the first arrow of Shinzo Abe's plan to exit deflation and return Japan to growth, the European Central Bank is dealing with the sovereign debt crisis in the periphery and requires ultra-low interest rates to ensure the Euro doesn't collapse as a currency, and the US has not even exited "extraordinary measures" and quantitative easing (buying Treasuries with newly printed money). Overall this indicates that ultra-low interest rates will persist for the foreseeable future. However, they can't continue forever and there is a very real risk of stagflation.

What happens when interest rates begin to rise? If you look at the cost of mortgages, you can immediately see the implications. Increase the ultra-low rate of 2.87% to a low 5.5% interest rate and the home affordability index changes substantially. The $350,000 mortgage now increases from $2000/mo. to $2500/mo. If they return to a normalized 7.5% interest rate, $2951. This will leave many people overextended. 

While a 30% decrease in affordability is not dangerous, and will not lead to a crash in the Canadian market, it does change the long-term outlook for housing as most people buy a house based on what they can afford monthly. 

For example, the couple that could afford a $350,000 home at 2.97% interest rates, can only afford a $240,000 home at a normalized rate.

When you look at the cost in the Greater Toronto Area (chart below), or any other metro area, that puts home affordability out of reach for a large segment of the population. As a result, this will lead to a long-term secular bear market for housing in Canada. 

The Soft Landing

While the Bank of Canada is doing what they can to ensure a soft landing for the housing market,  this soft landing is going to be maintained through "asset price stability". What that means is that the cost of an asset will remain the same, but not keep up with the decline in purchasing power as a result of inflation. This way the banks will avoid a downturn in the market, even though fewer people can purchase a home and prices will be falling in real terms. Basically creating a wealth illusion to avoid a hasty rush to the exits.

Hot Money in Canada

The big question is the foreign hot money - when the growth slows, will they stay in the asset class? To date, global central banks have pumped almost $7 trillion in liquidity into the market. That money is chasing returns, as 1% in bonds is not enough for high net worth individuals or institutional investors to counter the inflationary effects of QE. As long as the housing market is growing faster than that, Canadian homes will be viewed as a bit of a safe haven. As soon as growth slows to 1-2% from the current 4-7%, the view of the asset class will change and there may be a meltdown, especially in the condominium market which has absorbed the majority of foreign wealth (Vancouver, for example, has an entire condo development that is sold, but only 25% occupied).

Threading the needle is very difficult, and the meltdown will likely start in 2016-17. Will this lead to a crash or just a long period of stagnation in Canadian housing? Ceteris paribus, stagnation. However, with concerns about shadow banking in China, the Chinese housing bubble, the fate of the Euro, the unwinding of QE the world remains a very difficult place to navigate.

Mark Carney gives a great speech on Inclusive Capitalism

The New Spice Route (and the Role of America)

After the Second World War, the United States was the unrivaled leader of the "free world", with only the economically unstable Soviet Union offering a counter-balance to US global hegemony.

As the post-Soviet world begins to reshape into a  multi-polar world order, with China and the EU as the new main participants, control over the New Spice Route is going to become a continuing theme in global affairs. 

The most existential threat to global economic growth in 2014 is concerns about the global trade in hydrocarbons. Some of the worlds most important economies, and largest contributors to global growth rely on imports of hydrocarbons to fuel their growing economies. This is the great challenge to Asia especially as many Asian nations have very limited domestic supplies of oil and gas.

The existential crisis is most prevalent for Japan, following the Fukushima-Daichi nuclear plant disaster. Much of the Japanese Economic Miracle of the 1970s-1990 is due to relatively low cost of inputs from one of the world's largest systems of nuclear power. Following Prime Minister Yoshihiko Noda's decision to wind-down Japan's aging nuclear power plants, Japan has been spending large amounts importing oil and gas, specifically from the Middle East. This is putting pressure on global oil prices and making Japan's exports less competitive. 

Japan is an example to other Asian nations, like South Korea, Taiwan, Vietnam and Malaysia, as to the importance of the global hydrocarbon trade and the dangers of Chinese militarism in the South China Sea. Essentially, for these nations, if China is able to displace American naval superiority in the South and East China Seas, then they will be completely dependent on China, and face a crisis as China would have the ability to stop economic activity in the Asia-Pacific with an oil embargo.

As much as two-thirds of global trade flows through the Strait of Malacca and is managed through the major international ports of Kuala Lumpur and Singapore. This is trade from Asia bound for European consumers and Middle Eastern hydrocarbons headed toward energy-starved Asian nations.

Control of the Strait, as well as the Adaman Sea and the South China Sea is key for globalization to continue in the 21st century.

This is the most important global pinch-point and a geo-strategic imperative for the United States to ensure remains free to global trade. However, recent discoveries of hydrocarbon fields off-shore in the sea have led to a scramble to harvest those resources. Malaysia, Vietnam, Phillipines and China all claim ownership of the resource rights in the South China Sea. China (not shown on map) claims the entire South China Sea and this will be a cauldron of diplomacy in the coming decades. US and European engagement is necessary to counter-balance Chinese growth and protect the economic interests in the region.

The New Pharaohs 

The second strategically volatile region for global trade is the Red Sea. An overlooked concern of the Arab Spring and the overthrow of President Hosni Mubarak in 2011 was the Suez Canal. While the West received some guarantees from the Egyptian military that access to the canal would be maintained, this remains an concern for global trade as political uncertainty remains.

The Red Sea contains two main choke points, the first at the Suez Canal, the second at the Gulf of Aden. Currently, the Gulf of Aden is the most insecure area to navigate on the New Spice Route. Regional instability in Yemen, Sudan, Eritrea and the failed state of Somalia make this a difficult area of influence for the United States and European allies. This is an area the Global War on Terror has destabilized even further. Adding to the complexity is the question of nuclear negotiations with Iran and the concern in the Persian Gulf and specifically the strategically important Strait of Hormuz. 

As the center of the global hydrocarbon trade, the Arabian Kings in Saudi Arabia, Kuwait, UAE and Oman will continue to wield outsized influence and will become a more important military power in the 21st century as the war-weary United States winds down engagements in the region post-Iraq War.

It would be the expectation that US military-industrial complex will be investing heavily with American regional allies on the peninsula, and that the US Congress will allow a larger amount of arm sales to produce a counterweight to Iran, as well as allow for more domestic counter-terrorism activities.

Maintaining the Balance in the Mediterranean

The final leg of the New Spice Route is Europe's backyard. The Mediterranean is a region traditionally controlled by European powers. While the Strait of Gibraltar is the most secure pinch point in global trade, recent Russian movements have changed the dynamics of the sea and created a geopolitical crisis as Russia's annexation of Crimea can be seen as a threat to the West as it grants the Russians broader access to the Mediterranean basin and the ability to disrupt global trade in any future conflict.

This is where the Crisis in Ukraine extends to become a geo-strategic concern. Incorporating Crimea and the Port of Sevastopol into the Russian Federation grants Russian de facto control of the Black Sea. This creates challenges for NATO, as Turkey is a linchpin of that alliance, and this starts a balance of power situation for the region.

As Turkey continues is economic rise, it may seek broader assurances for its security by acting alone. Turkey faces many challenges on its Eastern flank as nationalist Kurds look to form a state in Northern Iraq and Syria. This is a domestic political concern for Turkey, home to 14 million Kurds.

Turkey also faces a refugee crisis as the Syrian Civil War extends into its third year. Add al Qaeda-linked organizations like Islamic State in Iraq and Syria (ISIS) and continuing unrest in the Levant, and Turkey becomes a more vital ally to the West in the new world order. Not only as a counter-balance to Russia, as it was during the Cold War, but also as a barrier to radical militants in the Middle East en route to Europe.

Overall, this bodes well for the continuation of American economic and political might in the 21st century.