Ever since the recession came to an end, bond investors have expected a persistent rise in long-term U.S. interest rates to be just around the corner. Conviction was especially high in the midst of the taper tantrum two years ago. Surely the end of QE and the return of self-sustaining growth should have been sufficient to bring the long bull market in bonds to an end? Instead, the collapse in oil prices, aggressive policy easing abroad and the surge in the dollar have pushed yields down over the past year and forced the Fed to delay the normalization of policy. Only now is the first rate hike coming into view after the unexpectedly strong October employment report.
Long term yields now imply that the Fed's policy rate will struggle to get above 2% during the current cycle, with markets pricing in a permanent inflation undershoot and a very weak outlook for real economic growth. This pessimism is not confined to the U.S.; in Germany, the U.K. and Japan, bond yields have also diverged significantly from likely nominal growth.
Pessimism has also led investors to dramatically reduce the compensation they require for holding long-term interest rate risk. That “term premium” has fallen back to the levels that prevailed during the 1960s as governments and central banks are expected to keep up their “financial repression” for many years, albeit using different instruments than during the post-war era.
In fact, the majority of the movement in 10-year yields over the past three years is explained by changes in the term premium. For example, almost all of the increase in 10-year Treasury yields during 2013's taper tantrum was accounted for by an increase in the term premium, as expectations for future short-term rates remained largely stable. Then in 2014, the term premium actually fell more than forward rates, as investor expectations for short-rates actually rose. The upshot is that any explanation for why long-term interest rates are currently so slow must incorporate the fundamental determinants of term premia.
Although the factors weighing on yields are numerous and complex, much of the fundamental explanation for low long-term yields boils down to the fact that the economic and financial aftershocks from the financial crisis are still being felt some seven years after Lehman Brothers collapsed.
Think about inflation. The financial crisis was a large negative shock that caused economic activity and labor utilization in the U.S. to fall well below its potential. The large and persistent output gap in turn put significant downward pressure on wage costs and firms' pricing power. External developments have added to the disinflationary environment. Meanwhile, the commodity super-cycle has rolled over, as lower growth and internal rebalancing in China has dampened demand for metals and the fracking revolution in the U.S. has led to a surge in global oil supply. Intriguingly, long-term inflation expectations have dropped with commodity prices, suggesting that investors believe that a structural shift in the inflation generating process has taken place that the Fed may be unable to counteract.
Policy mistakes at home and abroad have also played their part. It may seem counterintuitive given the proliferation of unconventional monetary instruments rolled out in recent years, but central banks have repeatedly underestimated the magnitude of the disinflationary forces weighing on their economies. The Fed had to initiate four separate asset purchase programs; the ECB incredibly tightened monetary policy just as the peripheral crisis was intensifying in 2011 and then took years to ease policy sufficiently; Sweden was so worried about excess household debt that it allowed underlying inflation to fall to zero; and Switzerland has given up on all pretence that it has an inflation target at all. It is telling that no developed country central bank has sought to raise its inflation target or introduce a price level target as a means of sending a credible signal that they genuinely desire much higher inflation. Little wonder then that markets are questioning central banks' long-term commitment to higher inflation.
But is it possible that bond markets are being overly pessimistic?
We have identified a number of pre-conditions for long-term interest rates in the U.S. The first is for the domestic recovery to become more self-sustaining, enabling the labor market to fully heal and eventually push wage growth and inflation back to levels consistent with the Fed's long-term targets. If inflation does rise and the Fed begins to increase short-term interest rates, we would expect inflation expectations to follow suit. Investors should also then demand a higher term premium.
The second is that we finally see a stronger capital spending cycle. The economy will only be able to absorb higher real interest rates if desired investment and the return on productive capital increases. In our view a major expansion of public investment spending would be especially welcome given the country's acute infrastructure shortage and the positive spill-overs to private sector activity. Unfortunately, Congress is showing little willingness to exploit historically lower interest rates in such an economically beneficial way.
Of course, it is not enough for the U.S. economy to return to health; conditions in the rest of the world must improve simultaneously. The Eurozone's double-dip recession, delayed monetary easing and subsequent depreciation of the currency have had a depressing impact on U.S. interest rates in recent years.
Jeremy Lawson is chief economist at Standard Life Investments.
