Financial Times - February 3, 2005
Why long-term bond yields are low By Samuel Brittan
The behaviour of bond prices is puzzling the financial markets. The US Federal Reserve has for some time been gradually raising the Federal Funds rate from the 1 per cent of a year ago towards what it regards as a more normal level, reaching 2.5 per cent this week. Yet, paradoxically, long term bond yields have continued to fall. In the US, they reached a high of 4.7 per cent last summer and have since dropped by about half a percentage point. There is little doubt that interest rates - international as well as US ones - are low for what is regarded as a recovery phase of the business cycle. Having at last abandoned their more unrealistic expectations about equities, some investors are unhappy that bonds do not offer a promising alternative.
Part of this grumbling merely reflects "money illusion" - the failure to take inflation into account. The high returns previously experienced in nominal terms from holding bonds were partly compensation for the fear that dollars and pounds would shrink in real value. But OECD real interest rates, obtained by subtracting an inflation index from the nominal yield, also show a pronounced long term downward trend - from about 6 per cent in the mid-1980s to 2 per cent recently. The message is confirmed by the yield on UK index-linked gilt-edged, which is now in the 1?-2 per cent range. The yield on the more recently introduced US TIPs (Treasury inflation-protected securities) is now also down t owards the 1? per cent level. These low returns are all the more impressive in the light of the common belief that the dollar and sterling are both overvalued and that bond yields must contain a risk premium to allow for this.
One can try to explain what has happened in terms of financial markets technicalities or the vagaries of monetary policy. For, despite recent central bank tightening, short-term as well as long-term real interest rates are still historically very low. On a Goldman Sachs computation they are well over one standard deviation below average. This gives an incentive to the "carry trade" in which participants borrow short to invest in bonds.
Yet there may be a more elementary explanation for low long-term real interest rates. Just as the price of bananas balances the supply and demand for this fruit, so the rate of interest balances the supply of savings against the demand for funds to invest. Monetary policy is important mainly at the short end and for its effect on inflation. But the important influence at the longer end is the balance of world savings and investment.
Thus, I come to the simple hypothesis that falling real interest rates reflect a growing shortage of attractive investment projects to absorb savings. The world is indeed supposed to be short of capital and we are told that we do not save enough. But what matters in this context is not the developing world projects that might be desirable but the number of projects world-wide that promise a commercial risk-adjusted return.
The reason why so much of the world's savings has gone to the US is surely just because of the dearth of such investment outlets elsewhere. In the 1930s, Lord Keynes feared that the rate of interest could not fall low enough to balance savings and investment at a reasonable level of employment. But up to now, world capital markets have worked well and interest rates have fallen enough to balance savings and investment without generating a depression.
We should, however, be grateful that governments and citizens are going slow on the exhortations of the great and the good to save more. If they did, the strain on financial markets might be too great and we really could have the much-feared Keynesian slump.
The authors of global co-ordination plans would like to avert this threat by balancing an increase in savings in the Anglo-Saxon world by a reduction in saving in east Asia and possibly the eurozone - although, of course, they do not put it in this way but talk instead of Asian currency appreciation and European economic stimulus. I noted in a previous column the lack of both knowledge and the authority to carry out this balancing act.
There may still be a problem. An article in the current NIESR Review argues that the UK savings rate is too low to fulfil the needs of British citizens. Tim Congdon puts forward a dissident view in the current Lombard St Review that if total savings - and not just the household variety - are taken into account, the savings rate has been quite adequate. In any case, there is no God-given rule that money invested in secure fixed interest securities should bring any particular rate of return. Keynes's "euthanasia of the rentier" could yet happen. Meanwhile, the obstinate resistance to the exhortation to save more is putting off the problem that the zero floor for interest rates might pose for monetary policy, and for which the Fed has wisely made contingency plans.