I have been thinking about Winston Churchill all week. Not because the world appears intent on supplying material for comparisons with the 1930s, but because of something economist Raymond Parsons said after the Reserve Bank’s recent decision to hike rates.
Parsons recalled Churchill’s unhappy experience as chancellor of the exchequer, when in 1925 Britain returned sterling to the gold standard at its pre-war parity of $4.86/£. The decision delighted the Bank of England and much of the financial establishment, but John Maynard Keynes warned that restoring the old exchange rate in a radically changed post-war economy would require deflation and place enormous pressure on British exporters, particularly coal and manufacturing.
In other words, Britain was trying to restore the monetary respectability of the world before 1914 even though the economic world underneath it had changed. Churchill later recognised the tension in characteristically memorable terms: “I would rather see finance less proud and industry more content.”
Parsons’ point was not that South Africa is replaying Britain in 1925. It was that economic circumstances change and policy trade-offs change with them.
That thought has been rattling around my head while watching the US 10-year Treasury yield climb through 5% and our own Bank raise the repo rate another 25 basis points (bp) to 7.25%. Because beneath all the talk of inflation expectations, second-round effects, term premia, output gaps and the like lies a much simpler question: how proud should we be making finance when the productive economy is barely growing?
The most interesting argument I encountered this week came from opposite ends of the bond debate.
US investment manager and macro commentator Cullen Roche, founder of Discipline Funds, has been pushing back against the alarm surrounding the 5% Treasury yield. Since 1960, he notes, the yield has averaged about 5.8%. Five percent is therefore hardly unprecedented. He also makes the point that doom-mongers tend to stare obsessively at America’s public liabilities while ignoring the enormous household and private sector wealth underpinning the US tax system.
Fair enough. But that misses the more important point.
The question is not whether 5% was normal in 1985. It is what happens when a financial system that spent the better part of two decades adapting itself to 2%–3% long-term money suddenly discovers that capital costs 5%.
House prices capitalised cheap mortgages. Commercial property capitalised low cap rates. Private equity capitalised cheap leverage. Governments accumulated debt at unusually low coupons. Equity valuations expanded around very low discount rates.
It is also why the observation by Fidelity’s director of global macro, Jurrien Timmer, about bond convexity caught my eye. At a starting yield of 5%, he calculates that a 100bp fall in the 10-year would generate roughly an 11.9% return, whereas a rise to 6% would cost the investor only about 1.9%. After years of misery, bondholders finally have some cushion.
Which is lovely if you are the lender, but less so if you are refinancing the building.
Vunani’s Warwick Lucas describes the 5% Treasury as a new “global discount rate”. It says: if you want my money for 10 years, I require considerably more compensation. And, crucially, this is no longer merely about guessing what the Federal Reserve does at its next meeting. The long end increasingly embeds inflation uncertainty, debt issuance, duration risk and a fiscal risk premium.
A forced hand
That’s where this becomes a South African story.
We can set our repo rate, but we cannot set the global price of capital. And that is what makes the Bank’s decision both understandable and deeply uncomfortable.
Alexforbes chief economist Mpho Molopyane puts the contradiction plainly: the Bank is having to “hike into a contracting economy”. Its fear is that the latest energy and food shocks bleed into wages and corporate pricing behaviour with a lag. By the time second-round effects are obvious, it may already be too late.
I understand that argument.
With US long yields above 5%, oil above $100 and global central banks tightening again, South Africa cannot wander off in the opposite direction, pretending exchange rates and capital flows are someone else’s problem.
Lucas makes precisely that case. A large interest rate divergence could expose the rand at exactly the wrong moment. In his view, the Bank’s hand is substantially forced.
But being constrained does not make the consequences disappear.
The Bank has cut its growth forecast from 1.6% to 1.4% to 1.2%. We must stop pretending monetary orthodoxy comes without an economic price.
South Africa has become rather good at demonstrating that we are sufficiently respectable to be lent money. The rand has held up better than it might once have done. Our monetary credibility matters. Fiscal consolidation matters. A lower inflation target may ultimately matter enormously.
But an economy cannot live indefinitely on respectability.
At some point somebody must build the factory, hire the worker, sink the shaft, finance the small business and take the entrepreneurial risk.
That’s why Churchill’s line has stayed with me.
We mustn’t lose sight of why we wanted credible finance. It was supposed to create the stable foundations upon which industry could prosper. But if the foundations become the entire building, something has gone badly wrong.
