I apologise in advance, but in this article, I want to delve into the implications of low-interest rates on the alternative finance sector via a model for how regulation, technology and markets interact. First off though, the bold claim.
We all need to get used to interest rates well below historical norms for the next few DECADES.
I have no problem with the idea that the US Federal Reserve might succeed in raising rates two or three more times over the next 12 months but my core contention is that we’ll see interest rates peak at 2.5% in the US, and much lower in the UK and Europe. I also think that the idea that central banks will massively slim down their balance sheets is bordering on delusional – confusing an ideological desire (get central banks out of free markets) with a pragmatic reality (we’re all addicted to cheap debt). Given that the supposed long-term average for interest rates is around 5%, I think we have to get used to the idea that interest rates will remain below 2.5% for most of the next few decades. Again, I’m sure there are people who think this is immoral, but it is in my view a necessity. We in the developed world are addicted to debt. Our wealth is increasingly expressed via property, which is itself being subsidised by low rates. If we want to stop this addiction to property as a store of wealth, we need to hike interest rates to levels where we’ll see 20 to 50% price crashes. Sadly that will also drag down bank balance sheets, crater the consumer sector and immediately result in a mass insurrection. Good luck with that plan.
So, we’re stuck with low-interest rates.
There are two wild cards though. The first is that we see a big resurgence in inflation trends in the big regional economies. If this did happen, we might be on the receiving end of a central bank over reaction i.e the central banks will panic, hike up interest rates too quickly and too aggressively, prompting the mother of all recessions. This is a possibility but I think it is unlikely.
We are mid-way through a long process of globalisation and profound technological change which is helping to keep a lid on prices and wages. This might result in a populist explosion which could see inflation soar but I think that is unlikely. The other possibility is that trend growth will increase as the pace of technological change picks up. This I think is more possible but again, it’s not necessarily likely. Nor would it necessarily result in higher inflation levels, especially if these innovations result in lower average wages (a likely outcome).
So, my default scenario is sub 2.5% rates for most of the next few decades.
How will the alternative finance space adapt to this?
The first systemic reaction will come from regulators. If central banks can’t control credit growth through their balance sheets and interest rates, they’ll pass the buck to regulators such as the FCA. These bureaucrats will force lenders to tighten borrowing criteria, shutting out huge swathes of the market from access to cheap money. We’ve already seen it in mortgages, and I think it will come to unsecured lending within the next few years. Proper KYC around a clients credit worthiness will be combined with new regs stopping automatic credit level increases and interest-free deals. We’ll also see the screws being tightened on all forms of property lending as the regulators look to slowly deflate housing markets.
Initially, this regulatory creep will be focused on the biggest institutions but we’ll see these forces hit the alternative finance sector within a few years. This because the regulators are increasingly aware of the next systemic outcome – INVESTMENT ENGINEERING. Whenever regulators force markets to adapt to stringent rules for core players, we see financial innovation intensify at the fringes. If investors can’t get a decent yield from core savings products, they’ll get more “alternative” – helped along by an industry only too happy to engineer new products. We’ll also see new innovations in the search for yield such as embedded leverage emerge, where the financial engineers design new types of products where layers of debt are compounded so as to increase investor returns. This layering of finance helped produce the collateralised structures that helped blew up markets in 2008 and 2009. They haven’t gone away and we can bet that someone, somewhere is dreaming up a retail product where extra leverage is included within the structure to boost returns.
Regulators will try and slam shut the stable door for much of this financial engineering but 8 times out of 10, they’ll be too late. Someone will be too quick to design a product with the highest headline rate and there will be too much demand from yield hungry investors.
Which brings us to what I call LEAKAGE. This is a proven phenomenon where domestic investors, hemmed in by ever tighter regulations, start to look abroad for new products and higher yields. The idea of crossing national boundaries in search of better income is already established in parts of the retail spectrum. ETFs tracking emerging market bonds have shot off the shelf in recent years and I’d expect to see a slew of new products emerge within the fintech space, designed to channel investors’ offshore, to jurisdictions offering higher yields. Chinese savers are already deep into this practise, following on from the example set by Japanese investors engaged in the carry trade for much of the last few decades.
TECHNOLOGICAL DISRUPTION is an independent variable in this scenario. If regulation is too tight, it might stymie change. But it could also accelerate attempts by innovators to MARKETISE assets and spaces that until now haven’t been turned into mass market products. Take one small example – residential homes. The regulators are already engaged in a none too subtle war against buy to let landlords, but they face a huge weight of demand from investor’s who have anchored all their expertise around investing in bricks and mortar. This has already encouraged property crowd funding sites to emerge. But why can’t we take this a stage further, and build fractional ownership and rental models, where investors can take part in the growth in the value of a property co owned by the resident who is also paying an additional yield to the investor? New technologies will help open up this market to a wider base, sending the regulators into fits of despair. The key technologies to watch are those that will FRACTIONALISE and MARKETISE nascent asset classes.
Stepping back though, we’ll see a powerful dynamic at work – the increasingly desperate SCRAMBLE for YIELD. As interest rates remain low, longer, investors will push up the price of all conventional income yielding asset classes, pushing down yields. Investors will fan out up the risk curve, eventually embracing all forms of illiquid and high yield. High net worth investors will lead the charge, but as I’ve described we’ll see financial innovators build new structures (income orientated investment trusts) which will let the mass market participate as well. Eventually all decent income investments with a moderate risk exposure will see yields dip below 6% as investors get more and more desperate – while ponzi like schemes and rip offs will keep up popping up offering yields above 8 to 10%. At some point though the demand for high yield will create a more systemic ponzi like risk, perhaps helped by technology.
One scenario jumps to mind. Some new platform offers lending products built around clever algos and AI technology looking at credit risk. Suddenly a huge pool of borrowers who were deemed as too risky are re-evaluated – and found to be less risky. These borrowers suddenly become more ‘reliable’ and investors harvest all the extra returns from lending to them. But then the algo is exposed, as borrower behaviour changes (influenced by the knowledge that credit is more readily available), losses mount, and investors start to bail out. Maybe such a scheme might be so big that tens of billions are lost.
All of these negative developments could of course be managed if central banks could push interest rates higher – suddenly all those boring savings products would seem a lot more attractive. But as I’ve said, we’re all too addicted to debt to cope. Another alternative is that we are all forced to accept lower returns on our savings/cash and react by increasing our savings rate. Again this is possible but I have my doubts that we’ll be able to engineer the behavioural change required. Whatever the outcome I would suggest that inequality will increase simply because a lucky few will have access to cheap credit while everyone is trapped on the outside – despite the best efforts of disruptors and innovators. In a world where access to credit gives you a better shot at having a decent life, low interest rates simply reinforce existing inequalities. The real challenge for innovators is to overcome this huge challenge – good luck!