Don't blame the financial crisis for low interest rates — they've been falling for 30 years

(February 10, 2015, posted in Economy)

There is lots in the media at the moment about how interest rates on government bonds in some developed countries are dipping below zero for the first time. This is indeed an historical moment, but it reflects a 30-year trend of collapsing yields rather than simply being a short-term phenomenon.

The chart below shows the interest rates on 10-year government bonds in the US, Germany, Japan, Switzerland and Sweden from Swedish bank SEB:
There are a number of factors driving this long-run trend, including ageing societies (which imply higher savings rates and lower productivity growth), low expected inflation due to greater central bank credibility and, most worrying, low expected returns on investment. These factors may have have been exacerbated by the financial crisis, but they were not created by it.

Lower rates, however, do carry with them some new risks. As SEB explain in a research note:

  • Investors accepting low or even negative interest rates suggests that they see alternatives that are worse than earning a negative return. This is bad news for developed economies that have already seen low levels of investment for over a decade.
  • Low yields may also lead to bad investments in companies or projects that would not have survived under more "normal" circumstances. Such investments risk going awry if interest rates rise unexpectedly (for example, due to an inflationary shock).
  • And, importantly, adjustments in investor return expectations are sluggish meaning that investors still demand returns above what their risk-tolerance can provide for them. This means that investment managers either have to disappoint their clients, at the risk of their fees, or increase the risk of the portfolios in order to deliver the expected returns.
Of course, the first and last of those risks may appear inconsistent with one another — either low rates cause investors to increase the riskiness of their portfolios, or it is caused by perceived low returns on investment. However, we may need to draw a distinction here between expected returns on investment and market returns.

Even in a stagnating economy it is still possible for investors to profit from taking short-term positions in certain company stocks or bonds that move in and out of favour. Yet overall such trading is effectively a zero-sum game unless there is ever more money coming into the system either through the growth of those companies or from money flowing in from overseas.

So it is possible to have low growth expectations and increased risk taking. What is discouraged in such a scenario, however, is long-term investment in the types of productive projects that are likely to lead to higher growth in future. This is arguably exactly what we have seen since the late 1990s with net investment falling across the developed world.

Low rates here should be seen as a symptom rather than a driver of falling investment spending.

And this phenomenon may last much longer than people are currently expecting. If the current trend of falling inflation were to give way to deflation, for example due to ageing societies forcing up saving and lowering demand, then governments may be able to continue borrowing at negative rates as the real return — the amount paid out after adjusting for inflation — would remain positive if prices were falling by more than investors were having to pay the state to hold their money.

Even if the risk of outright deflation isn't realised, a combination of a prolonged period of low interest rates and the growing reliance by central banks on unconventional policies such as QE aimed at lowering long term rates could lead to a reduction in the term premium of government bonds (governments traditionally have to pay higher interest rates to borrow for longer periods). As SEB states: "As we can see it, [there is nothing] to prevent large portions of the yield curve from lying below zero".

In other words, the new reality could "eliminate the predictive ability of the [bond yield] curve" meaning that investors may not in future be able to rely on government bond markets to signal economic stress. But the good news is that they could offer their own solution. Here's SEB again:

The prevailing low yield situation allows very affordable financing of long-term public sector investments, such as infrastructure projects. This is good for short- and medium-term growth and a country’s long-term production capacity.

Unfortunately very few governments appear willing to borrow to invest even with interest rates falling into negative territory. It seems the soft tyranny of low expectations is as much a crisis of state confidence as it is of the private sector's animal spirits.

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