In memory of Dr. Andreas Höfert

Low interest rates are here to stay… for now

| Tags: Andreas Höfert

The aftermath of the financial crisis has been characterized by lower economic growth and much lower inflation than what was experienced before the mayhem. This alone could explain why interest rates are so low. Real interest rates usually reflect real growth, and the difference between nominal rates and real ones is explained by inflation expectations.

Nevertheless, this simplistic explanation is only halfway satisfactory. Taking actual inflation as a proxy for inflation expectations, or alternatively, taking central banks’ inflation targets as a proxy shows that, at least for the US, the UK, Germany and even France, real rates are at historical lows; and this is despite government indebtedness being close to or above 100% of GDP. This means either that the future real growth rates that market participants are expecting for these economies are near zero or that we need another explanation.

One trick that economists have in their toolbox - when confronted with prices that are not obvious at first glance (and remember that very low interest rates mean very high bond prices) - is to go back to supply-demand fundamentals.

An overly expensive price may reflect a lack of supply and/or excessive demand. One might think that there is a huge supply of risk-free government bonds from developed economies due to the record high debt held by many countries. However, looking closer, we discover that while the supply is plentiful, not many are risk-free. According to a study by economists Ricardo Caballero and Emanuel Fahri, we could define “safe bonds” in 2007 as US Treasuries, bonds by US government agencies, some US privately-issued asset-backed securities and German, French, Italian and Spanish government bonds. These bonds accounted for roughly 37% of world GDP. Five years later, only US Treasuries as well as German and French government bonds could still be seen as “safe.” The ratio of US Treasuries to world GDP rose sharply during this period to 15.8% from 9.2%. So did German and French government bonds. However, this rise wasn’t enough to compensate for the disappearance of the rest from the “safe” bucket, leading to an overall drop in “safe” bonds to 20.6% from 37% of world GDP.

But even without focusing just on the safest segment of the bond market, some of the ongoing structural shifts in the world economy (for example, from capital intensive industries to far less capital intensive internet app and service providers) could ultimately lead to bond market shortages. Facebook and Instagram need far less capital than AT&T and Kodak did 30 years ago.

On the demand side, what former Federal Reserve Chairman Alan Greenspan defined as a “conundrum” and what former Fed chief Ben Bernanke explained as a “saving glut” hasn’t really disappeared after the financial crisis. Changing demographics - with an aging population, supposedly excessive savings in some emerging markets - and even behavioral changes by households who don’t want to repeat the same leveraging errors which triggered the financial crisis can lead to excessive demand for “safe” assets. This demand has been rivaled by many central banks buying the same “safe” assets. While the Fed will likely exit quantitative easing in a few weeks, both the Bank of Japan and the European Central Bank still face ailing economies and deflationary pressure, and are likely to take the baton from current Fed chair Janet Yellen.

Moreover, so-called “captive” investors (like pension funds) might be forced by rules and regulations to buy “safe” assets, even though they would prefer not to. In fact, the more a government is indebted, the more it is likely to use financial repression tools to ensure that the real interest burden it pays on its debt remains low.

All these arguments plead in favor of an environment where real yields on “safe” assets might stay lower for longer. Is this enough to make those assets attractive? On the contrary, even though such assets might seem a good place to store value, costs of carry or in economists’ jargon costs of missed investment opportunities are rather large when real interest rates are at zero. Not to mention the loss of purchasing power if real interest rates go into negative territory.