Why rising rates are good news
By Martin WolfPublished: December 14 2010 20:38
Terrified by irresponsible fiscal and monetary policies, the bond market vigilantes are out in force. So rose the cry, as rates on government bonds jumped last week. Alas for the panic-mongers, this glib story is nonsense. What is happening is a move towards normalisation. That is excellent news. Policy is working. That does not mean it could not be improved. But what is astonishing is not how high nominal and real interest rates have become, but how low they remain. They are likely to rise substantially if and when less abnormal conditions arrive.
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What has happened? Between November 30 and December 13 2010, the yield on 10-year US government bonds jumped by 0.49 percentage points. Corresponding jumps in German and UK bonds were 0.30 and 0.34 percentage points respectively. The rises between November 4 and December 13 were bigger still, at 0.80, 0.46 and 0.61 percentage points for the US, Germany and the UK.
What has happened? Between November 30 and December 13 2010, the yield on 10-year US government bonds jumped by 0.49 percentage points. Corresponding jumps in German and UK bonds were 0.30 and 0.34 percentage points respectively. The rises between November 4 and December 13 were bigger still, at 0.80, 0.46 and 0.61 percentage points for the US, Germany and the UK.
Are these jumps significant? No. In the case of the US, rates are back where they were in June 2010, before the marked fall in optimism about economic prospects revealed by the decline in the consensus forecast for growth in 2011, from 3.1 per cent in June to 2.4 per cent in September. Moreover, on December 13 yields on 10-year bonds were still only 3.28 per cent in the US, 2.91 per cent in Germany and 3.68 per cent in the UK. Yet between January 2003 and July 2007, on the eve of the crisis, yields on US 10-year bonds averaged 4.4 per cent. Rates at least that high represent normality and, with luck, that is where we are heading, as the Federal Reserve and other central banks have long been hoping.
To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations. Fortunately, inflation-indexed bonds allow us to do just that. In the US, the recent rise in nominal rates is explained almost entirely by the rise in the real rate, not by a rise in implied inflation expectations. To be precise, the rise in real rates turns out to explain 76 per cent of the jump from November 30 2010 and 83 per cent of the jump from November 4 2010.
This is less true in the UK, where real rates remain very low, while inflation expectations are close to 3 per cent. Moreover, not only is the recent rise in US inflation expectations strikingly modest, but expected inflation seems to be just over 2 per cent, which is where the Fed wants it to be. US real rates also remain strikingly low, at just over 1 per cent. In a normal world, one would expect these to be far higher.
Do these jumps in long-term interest rates mean that the Fed’s quantitative easing programme has failed? Absolutely not. The Fed’s aim is to make rates lower than they would otherwise be and so raise economic growth and eliminate any threat of deflation. Rates are still remarkably low. They are rising because of a jump in real rates that almost certainly reflects improved prospects for growth. I would imagine that the Fed is pleased with the picture it sees before it, even though the deal on fiscal policy between President Barack Obama and the Republicans, which removed the possibility of a sharp contraction, may be more important than the Fed’s monetary moves.
Are long-term interest rates likely to rise still further? Definitely. After all, if long-term real interest rates and inflation expectations were both around 2 per cent, one would expect yields on conventional bonds to be at least 4 per cent – and more if one also allowed for inflation risk. But, in its thought-provoking new report on the cost of capital, the McKinsey Global Institute argues we will not go back to where we were before the crisis.* It argues, instead, that we may be at the beginning of a secular rise in global real interest rates, as the investment programmes of the emerging world make up a rising share of the world’s demand for capital. If so, yields on government bonds in highly rated high-income countries might end up above 5 per cent in normal conditions.
During the past few decades we have seen a secular fall in real interest rates. In the UK, for example, real interest rates have fallen from 3.8 per cent in 1992 to less than 1 per cent today. Interest rates on conventional bonds have fallen still further, as inflation expectations and inflation risk have declined. Behind that decline in real rates, argues the McKinsey Global Institute, was not so much a savings glut as an investment dearth. The latter was due to a sharp fall in the rate of investment in the high-income countries, as postwar reconstruction and catch-up on US productivity ran out of steam. Investment fell from 26.1 per cent of world output in the 1970s to a mere 20.8 per cent in 2002.
Now this fall seems sure to reverse, as emerging countries build up their economies. Moreover, global desired savings are also likely to fall, as ageing bites and consumption soars in big emerging countries. The effect will be to drive up demand for savings relative to supply and so raise the real rate of interest.
Historically, real interest rates of 3 per cent were normal. Imagine, instead, that they reached as much as 4 per cent. So yields on high-quality bonds might well reach 6 per cent. If all goes well, then, the real and nominal yields we have seen in this crisis marked a secular trough. Only if recovery fails and deflation sets in might long-term rates fall substantially in the US or Germany.
So far, then, so good. But does this mean there is nothing to worry about? Of course not. Central banks do need to watch inflation expectations carefully. They seem to be well anchored in the US and the eurozone, but far less so in the UK, where the Bank of England has to be cautious. Moreover, while there is no sign at all of serious concern about default or inflation in the US bond market (though the gold market – that classic market for hysterics – differs), policy could certainly be far better constructed. The best policy combination for the US would be an effective fiscal stimulus, in the short run, and a plan for strong fiscal consolidation, in the long run. Given that the new US deal certainly does not represent the former and the failure to achieve the latter remains evident, it is striking just how low the costs of borrowing for the US government do remain.
In all, what has happened in bond markets is encouraging. Rates are rising, as depression psychology dwindles. With luck, the recovery is going to take hold. Hurrah!
* Farewell to cheap capital? www.mckinsey.com/mgi/publications/
Copyright The Financial Times Limited 2010.
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