For years, we have all been saying that interest rates must increase, that they can’t remain at historically low levels, and that the bull market in bonds must end after 30-plus years. After all, how long will investors be content to “earn” negative real yields?
There is an emerging view that interest rates may stay “lower for longer,” the new catchphrase of the moment. There are a number of factors that are impacting the level of interest rates globally and are expected to continue to do so for the near to medium terms. These include continued high levels of global debt, a global savings glut, weak investment and consumption in the developed world, and increased demand for safety.
While the popular press continues to talk about the debt levels incurred by North Americans relative to their net earnings, the bigger debt story lies in Europe and some of the emerging market (EM) countries, as much of the debt growth relative to GDP since the global financial crisis has occurred in EMs, particularly China. This has removed large amounts of capital from the global pool and—combined with central bank actions to facilitate liquidity and drive equity markets higher (through quantitative easing programs)—has placed downward pressure on real interest rates and reduced the cost of capital. This is good news for consumers, companies and governments as it has permitted them to continue to finance the oceans of debt that they have built at a very reasonable cost. It has also provided a significant incentive for policymakers to attempt to keep rates low.
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Despite the secularly low cost of capital, the global financial crisis has taken a severe toll on the levels of investment undertaken in many developed economies. Households, businesses and governments have invested much less than their incomes since 2008 (despite the best efforts of many central bank stimulus programs), reducing the demand for the global capital pool and real rates along with it.
Contributing to the pre-crisis reduction in real interest rates is the increased demand for safety by many investors. This has been driven by geopolitical concerns, policy initiatives and demographic factors and has led to a desire to hold increasing amounts of sovereign debt. In the medium term, while the expectation is for an upward pressure on interest rates, rates will likely go up slowly due to these competing influences.
Read: Opportunistic credit: A fixed income strategy for the times
Many developed market economies and some EM ones (such as China) are set to age rapidly, reducing the amount of net new savings in the long term, as retiring populations spend their savings. While this should ultimately increase real rates, it may take some time. Near term, savers globally are earning a paltry return for their “safe” assets, which has forced many, especially the retired and near-retirees, to save even more to be able to live off the income these assets generate.
Policy initiatives such as Basel III, Solvency II and the Volcker Rule have compounded this situation, with many formerly risk-taking institutions no longer incented to do so. Aging societies are placing strains on public purses as a greater amount of “national income” is allocated to health- and pension-related programs.
Global growth remains constrained as growth in the EMs slows and Europe falls back into recession and potentially deflation. Investment in infrastructure in China, Brazil and other EM economies is declining along with their use of resources. This directly impacts the anticipated level of economic activity in many EM economies and resource-heavy economies such as Canada and Australia in the near term. India appears to be the exception as its economy is domestic led with approximately 50% of the country’s population age 25 years or younger. Over the medium term, as the EM economies rebalance, net savings are expected to decline, which will place upward pressure on interest rates.
Read: Bond allocations: Adjusting to changing rates
Counterbalancing this in the near term is the deleveraging that is still taking place in Europe and deficit reduction initiatives in most developed market countries. Continued indebtedness and forced bank recapitalization in Europe are placing downward pressure on consumer, corporate and government spending. In fact, many European countries have reduced their deficit reduction programs in favour of spending/stimulus initiatives in an attempt to kick-start their anaemic economies.
High unemployment, especially among the youth, has continued to drag on many of the European economies. While North America, led by the United States, is experiencing modest growth, there remains slack in the economy with unemployment (and underemployment) a concern. Participation rates are at the lowest level in more than 40 years. While the U.S. Federal Reserve has stopped its bond buying program, there is no indication that it will increase interest rates rapidly, given its concern about the fragility of the recovery.
Hence the term, lower for longer. This dynamic has been reflected in long-dated bond pricing, with yields falling back toward global financial crisis levels. So we should brace for more of the same for the next few years—tepid growth, combined with low interest rates, resulting in many unhappy retirees.