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Real interest rates, both long and short duration, have been on a steady decline since the 1980s. Some analysts believe that thanks to the , rates will never be able to breakout higher again. However, this view isn't held by Bank of America Global Economist Ethan S. Harris.
In a report published at the end of last week, Harris and team lay out the reasons why they believe that the downward slide in both short and long real interest rates is likely to reverse.
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Real Interest Rates Going Into Reverse
Harris claims that since the 1970s, there have been five stages to the depression of real interest rates.
The story begins in the 1970s, when central banks lost credibility around the world by letting inflation run riot. Repeated inadequate tightening by central banks caused double-digit inflation. As a result, ex-post real interest rates were unusually low for extended periods of time and investors demanded high levels of inflation protection. In the US the average real 10-year yield was 1.6% in the 1970s, but it had risen to 5.3% in the 1980s.
Following the 1980s, by the 1990s central banks had learned their lessons and core inflation bounced around newly established 2% or so inflation targets. During this period central banks regained their anti-inflation credibility.
However, in the early 2000s global growth started to trend lower. As BoA's analysts explain:
"In theoretical models the equilibrium level of real interest rates (r-star) is often linked to trend growth in the economy. Perhaps the best-known work on equilibrium real rates is by Holston, Laubach and Williams. Using a simple framework they show that the neutral rate has fallen in four major economies, from a range of 2.2%-3.5% in 2000 to 0.1%-1.6% in 2Q 2017. In much of the discussion, this is treated as a permanent drop, with roughly half explained by the slowdown in trend growth."
As growth slowed, and bond yields remained low, the "savings glut" in emerging markets emerged. China built an enormous volume of FX reserves and consumers across Asia have been saving aggressively due to the absence of social safety nets. These two factors have increased the demand for safe haven assets, depressing rates. The fifth and final stage of this process was the financial crisis. While the saving glut focused on the excess demand for fixed income assets in general, the 'safe asset shortage' focused on the more narrow shortage of assets that could survive a severe financial crisis. According to BoA, about 40% of the global supply of 'safe' assets was wiped out between 2007 and 2011 -- the demand for those remaining assets has caused a supply/demand imbalance. Central bank actions since the crisis have only exacerbated the shortage.
Reversing course
BoA global economist Ethan Harris believes that all of the above factors, that have weighed on real interest rates since the 1970s, are going into reverse. For the following reasons:
- Central banks are starting to unwind balance sheets
- The supply of 'safe' assets will likely be boosted by a gradual rebound in budget deficits in the major economies
- Memories of the crisis are fading
- The saving rate in China has already fallen significantly and is likely to continue to drop as the population ages
- China's FX reserves have been roughly flat over the last year and are down nearly $1 trillion from their peak level of $4 trillion.
And finally:
"Finally, an important exception to our story is the continued weakness in trend growth. Demographic trends point to further weakening in potential growth, not just in DM but also in key EM countries like China. However, there is a critical caveat here: a careful look at the history of real rates shows a very weak correlation with trend growth in the economy.Timing is tough, but the preponderance of evidence points to rising, not falling, equilibrium real rates in the coming years."
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