Currently official interest rates in developed countries remain close to zero (or as near to zero as makes no difference). Real rates of long maturity bonds (i.e. with a maturity of 20 years or more) in Western countries are also at historically low levels.
As we head into the final quarter of 2015 major rises in official and long-term real interest rates do not appear imminent. In this post we review the factors that have driven real interest rates - arguably the most important valuation in financial markets - to current levels.
An extraordinary environment
The current interest rate environment is a unique, unprecedented event. This year's annual report of the Bank for International Settlements described the situation as follows:
"Interest rates have never been so low for so long (exhibit 1 below shows a weighted average of real policy interest rates for the eurozone (Germany), Japan and the United States for the period from 1970 to June 2015). They are low in nominal and real (inflation-adjusted) terms and low against any benchmark. Between December 2014 and end-May 2015, on average around USD 2 trillion in global long-term sovereign debt, much of it issued by euro area sovereigns, was trading at negative yields. At their trough, French, German and Swiss sovereign yields were negative out to a respective five, nine and 15 years. Such yields are unprecedented. Policy rates are even lower than at the peak of the Great Financial Crisis (GFC) in both nominal and real terms. And in real terms they have now been negative for even longer than during the Great Inflation of the 1970s. Yet, exceptional as this situation may be, many expect it to continue. There is something deeply troubling when the unthinkable threatens to become routine."
We are, in terms of interest rates, in an extraordinary situation (we may be getting used to it but that doesn't make it any less extraordinary). This low interest rate environment is closely linked to the prospects for growth in the world and the return on real assets. In history there appear to be no precedents for the current situation - in the 19th century, financial instruments that could be used to measure the level of real rates did not exist. Nonetheless, we can deduce from the predictions historians have made of inflation rates at that time, that real interest rates never fell below 2% in the 19th or 20th century.
This post seeks to review some of the principal factors that explain the fall in real (and nominal) interest rates. A second article will discuss the circumstances that could lead to a significant rise in long and short dated real interest rates.
How did we get here? What are the factors that explain the fall in real (and nominal) interest rates?
If we look at the evolution of real interest rates in the long term we see that there is a steady decline. The fall in real policy rates since the early 1980s (see exhibit 1) can be divided into three distinct periods:
- The period before 1985 when real policy interest rates were around 4%.
- Lower real policy rates at a level not exceeding 3% between 1995 and 2007.
- The Great Financial Crisis (GFC) in 2008 which provoked a fall in real policy rates to zero and then into negative territory.
Exhibit 1: An exceptional and persistant fall in G3 real policy (1) rates.
(1) Nominal policy rate less consumer price inflation excluding food and energy, weighted averages for the eurozone (Germany) , Japan and the United States on rolling GDP and PPP exchange rates.
As real interest rates fell, valuations of real assets rose; (i) housing
The evolution of real rates is linked to the residential real estate market - the valuations of real assets (that is to say, for example, residential property in the UK and eurozone (particularly Spain)) rose as real rates fell. This was not a coincidence…
Indeed, the fall in real rates resulted in a significant expansion of lending and credit used in the financial system (expansion of the balance sheets of financial entities, increased use of leverage in the financial system) and fragilised the financial system.
The implosion of the housing market triggered the GFC. During the boom years, collateralised real estate assets were an important source of collateral in debt markets. However, the boom in real estate prices proved to be an illusion. Real house prices typically cannot rise constantly - high valuations leads to increased supply (except for instance in the UK where there are constraints on housing developments), which weighs on prices.
When the housing bubble burst following the excessive accumulation of debt, investment in housing fell rapidly. The threat of a severe economic crisis led, over a period of six to seven years (from 2008-2009 onward) to a convergence between the monetary policy of Western central banks and that of the Japanese central bank - policy interest rates fell to close to zero, where they remain to this day.
As real interest rates fell, valuations of real assets rose; (ii) equities
Logically in a low interest rate world, it is to be expected that the real valuations of equities would tend to be relatively high. As real valuations of equities tend to be volatile it is preferable to use a metric that detrends their valuations (e.g. via an inversion of Shiller's cyclically-adjusted price earnings ratio) in order to get an idea of the level of valuations on a historical basis. Such measures suggest that over the last 10 to 15 years, the real return on equities was rather low. Of course, this level of returns occurred in an environment of very low real interest rates. It would therefore seem plausible that real equity returns would be vulnerable to a significant rise in real interest rates.
A savings glut drives down real interest rates and contributes to the formation of a financial bubble
The period of falling real rates from 1998 onward is probably explained by the fact that the most important Asian economies had learned the lessons of their own economic crisis in 1998 by deciding to position themselves as net lenders and not as net borrowers – in the world’s financial market. In order to become independent of foreign investors, they began to build up large foreign exchange reserves. They therefore became providers of capital to the global financial system (which is not necessarily logical for dynamic economies with high growth rates). This change met a need in the West to counter the trend towards current account deficits (in the US and UK) reinforced by the development, in the eurozone, of a large trade surplus in Germany and the Netherlands.
The imbalances between savings and investments contributed to a favourable environment for the formation of a financial bubble. It should be noted that monetary policy was an exogenous factor (it is real savings and investment flows that were the key factors within the financial system driving real rates down).
This is borne out by the fact that when central banks did raise official rates (e.g. the Bank of Japan in 2000 and in 2006, the European Central Bank in 2008 and 2011 or the Riksbank in 2010/2011), they subsequently had to change course and revert to the downward trend.
The GFC reinforces the paradigm of a savings' surplus and weak demand for investment capital...
When the financial crisis erupted, it gave rise to a dramatic increase in the level of desired savings, which weighed on the level of real interest rates. It is the imbalance between excessive savings and weak demand for investment capital that is probably one of the main explanations for the current level of real interest rates. Monetary policy reacted in relation to these imbalances in adapting itself to deal with the consequences of a savings surplus world.
...leading to monetary easing, which so far has failed to kindle a rise in inflation
The start of monetary easing dates back six to seven years ago in most developed countries. Unconventional monetary policy led to extraordinary increases in the size of central banks' balance sheets. Despite fears that this policy would create inflation, inflation rates have continually declined. Today, core inflation (that is to say the rate of inflation excluding the volatile components that energy and food) is below its target in most countries. There are no signs of rising inflation in developed economies (despite the efforts of central banks to reflate their economies).
In the eight years since the start of the GFC the growth of global debt has outpaced world GDP growth
We find ourselves in an environment where nominal interest rates are ultra-low; Germany has been able to issue debt for 30 years at a rate below 1%. It is likely that these conditions, which are more like those of an economic depression, have become established because the deleveraging process among households and corporates is not very advanced (see exhibit 2 below).
Exhibit 2 – Change in levels of the global stock of debt outstanding, in USD trillion, constant 2013 exchange rates.
- Figures do not sum to total, because of rounding.
- Q2 2014 data for advanced economies and China; Q4 2013 data for other developing countries
Recent events in China - contributing to a lower for longer outlook for real interest rates...
Emerging markets, of which China is of course by far and away the most important, came through the GFC rather well. Their relative strength supported the level of demand in the global economy and hence the level of real interest rates.
In China the impact of the GFC really became apparent in 2008 when the growth strategy based on exports reached its limits as growth in the world weakened. To counter this situation, the Chinese authorities promoted a collosal investment boom. This led to a rise, over a period of around five years of the investment rate from 42% to 48% of GDP. This would appear unsustainable in an economy where GDP growth is slowing. If, as recent events seem to suggest, the pace of investment in China is now declining, then the consequences will tend to be deflationary. There is therefore no apparent reason today to expect a significant rise in either nominal or real interest rates. Developments in China would certainly seem to tend toward prolonging the low interest rate/lowflation environment.