Focus
October 06, 2023 | 13:01
No Longer Low for Longer
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
No Longer Low for LongerThe highest borrowing costs since before the financial crisis have upset cheery assumptions about asset values, roiling bond and equity markets and threatening to upend house prices next. While it’s no surprise that long-term rates have risen alongside the highest policy rates in two decades, virtually nobody expected them to scale 16-year peaks. |
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Since the Great Recession, easy money policies, a global savings glut, and economic shocks such as the Euro debt crisis and pandemic have held down borrowing costs. The 10-year Treasury yield averaged 2.4% from 2008 to 2022, three full percentage points below the mean of the preceding 15-year period. But now, it’s taking a serious run at 5% again, begging the question of whether it will return to the lofty norm prevailing before the financial crisis. While we still expect bond yields to retreat as the economy stalls and inflation cools, the following factors highlight upside risks. 1) A resilient economy. Despite the Fed’s aggressive action, the U.S. economy could see growth topping 4% annualized in the third quarter. Though pandemic savings have shrunk, consumers continue to propel the expansion thanks to the strong job market and the ability to lock-in mortgage rates for three decades. Still, headwinds such as student loan repayments and the autoworkers’ strike are swirling, and past rate hikes will take an increasing toll on demand. Moreover, higher interest rates in other countries have deeply chilled their economies, suggesting it’s likely just a matter of time before the U.S. follows suit. |
2) Increased government bond issuance. The surge in sovereign debt during the pandemic (which was partly needed at the time) could compete for private savings and pressure global rates higher for years to come. Moreover, even at the top of a business cycle, the U.S. budget deficit has doubled to $2 trillion in the past year, equivalent to 7% of GDP (Chart 1). The Congressional Budget Office projects the shortfall will average 6% of GDP in the decade ahead, a much longer stretch of profligacy than even after the Great Recession. 3) Rising risk premiums on government debt. In early August, Fitch downgraded the U.S.’s credit rating after another wrestling match in Congress over the debt ceiling. Moody’s recently warned that a government shutdown (looming after November 17) would be further evidence that political brinkmanship is interfering with fiscal management, and is unbecoming of a triple-A rated nation. Greater risk aversion would require more compensation for investors to hold Treasuries. Other countries also aren’t exactly beacons of fiscal probity, pressuring global rates higher. |
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4) Decreased demand for government bonds. Fed quantitative tightening currently caps monthly reinvestment in Treasuries at $60 billion, and the program looks to continue at least until policy rates decline. Since June 2022, its holdings of Treasury securities have shrunk by over $800 billion. Meantime, other countries aren’t stepping up to the plate to pinch hit. International holdings of U.S. Treasury securities appear to have plateaued. China cut its Treasury holdings by half a trillion dollars in the past decade, to 11% of the total foreign share from 23% in 2013. Top holder Japan has also trimmed its portfolio in recent years. Waning foreign demand won’t help the price of Treasuries (Chart 2). |
5) Demographics. The relationship between demographics and interest rates is complex and unclear. Populations are aging in China, Japan, Europe and, to a lesser extent, North America. Unless offset by increased immigration of younger folks, this demographic shift will reduce growth in the working-age population, possibly leading to chronic labour shortages and steady pressure on wages and prices. That may not be an issue for Canada, which is seeing the fastest population surge in nearly seven decades, almost entirely driven by immigration. But this rapid growth could also pressure inflation if suppliers and home builders can’t keep up with demand. Still, retirees will also reduce borrowing and spending, and also typically become more risk averse as they age, favouring fixed-income investments. This could allay upward pressure on rates. 6) Higher potential growth. While an older population may reduce long-run economic growth, the effect could be offset by rising productivity. In addition, increased use of AI technology could lead to increased business opportunities and higher returns on investments. However, the impact of higher productivity on interest rates could be tempered by a reduction in unit labour costs and inflation. 7) Deglobalization. After surging for two decades, growth in world trade has waned since the financial crisis, aggravated by the U.S.-China trade war starting in 2018 (Chart 3). Global trade volumes even shrank 3% in the year to July, which is rare outside of a recession. Tariffs and trade barriers tend to feed inflation, though they also reduce investment and potential growth, suggesting an ambiguous effect on rates. Still, new industrial policies aimed at reshoring supply chains imply higher costs. U.S. legislation in recent years has taken aim at reducing the nation’s dependence on the global supply of goods at the forefront of the AI (microchips) and electrification (EVs, batteries) revolutions. |
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8) Climate change initiatives. Increased costs related to the transition to a greener economy could pressure inflation and rates higher. Governments and businesses will be spending (and borrowing) trillions of dollars on investments to electrify the economy and move away from fossil fuels in coming decades. However, the IMF also notes that, by raising energy costs, the transition may also reduce overall investment demand and interest rates in the medium term. 9) Higher inflation expectations. After a long period of price stability, the recent surge in inflation to four-decade highs threatens to unhinge expectations that were once firmly anchored to the 2% target. Central banks continue to warn that the longer it takes inflation to subside, the greater the chance of longer-lasting effects on wage settlements and pricing behaviour. Policymakers may need to hold rates high for longer to earn back credibility as guardians of price stability. Meantime, lenders could demand an extra premium on long-dated securities as compensation for the risk of higher inflation. So far, implied inflation rates derived from inflation-protected Treasury notes have risen just a few basis points above the past-decade mean. |
The above factors could imply a higher neutral policy rate. Fed policymakers currently peg this long-run rate consistent with stable employment and inflation at between 2.4% and 3.8% (Chart 4). The wide range reflects the difficulty of estimating something that can’t be seen and moves with time. The median estimate has ratcheted down from above 4% a decade ago to 2½% today, though Chair Powell suspects it might be higher. As do we, possibly toward the upper end of the 2½% to 3% range. Those factors could also imply a higher term premium on long-term issues. The 10-year Treasury rate has averaged one percentage point above the fed funds rate in the past six decades. If this relationship holds, it could put the benchmark yield in a range of 3½% to 4% in the medium term. But even that might be too low. |
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Bottom Line: Pressured by inflation fears, large government debts, and shrinking global trade, the era of low interest rates looks to be over. This assumes, of course, that the U.S. economy avoids a hard landing—the odds of which would rise if rates go too high. |