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interest rates outlook - low for long

January 2021

The bond market sell-off: is this it?

Has the pandemic shifted the pendulum for rates for good?

 For the past four decades, interest rates have relentlessly headed lower. Will Covid-19  turn that trend on its head, as it has done with so much else in the world? At first glance, it might seem so.

The onset of the pandemic has, after all, brought with it unprecedented spending by governments across the world, whether affordable or not, with the Rubicon of simultaneous monetary and fiscal easing crossed in a matter of weeks. Some countries are now close to adopting the kind of central-bank financing of public spending envisaged by Modern Monetary Theory, a measure not long ago at the outer fringes of economic thinking.1

So, with policymakers apparently content to let public debt burdens climb, is the world about to enter an era when interest rates and inflation are much higher? In short: are bonds truly done here?

Fig. 1- Low for long
US core inflation and 10-year US Treasury yield, %
US core inflation

Source: Bloomberg. Data covering period 01.01.1961-01.11.2020.

While interest rates across developed markets are already low and levels of monetary stimulus are unprecedented, we do not believe that an inflation surge is imminent or that the downward move in rates is about to abruptly reverse. Even as we emerge from what has been the biggest shock to global growth since World War Two, inflationary pressures are in fact on titling to the downside. Inflation remains negative in many European countries and very low in other large developed economies such as Japan. In the US, inflation remains under control while in China, it looks to have peaked. 

Cyclical factors can cause some short-term changes in the market's interest rate expectations, but official interest rates should stay low for the foreseeable future to allow the global economy to recover following the pandemic shock. It took the US Federal Reserve several years to hike rates following the last recession during the Global Financial Crisis in 2008-2009. We would argue that it could take even longer this time, given the Fed’s new policy framework, the size of the its balance sheet and the fact that inflation is, on average, about 0.5 per cent lower now than it was at the end of 2009. 

One key macro-political shift that is likely to keep rates low is the steady erosion of the “Washington Consensus”. The term was coined by the English economist John Williamson in 1989 to describe the standard cocktail of austerity (public spending restraint), deregulation, trade liberalisation and sound money prescribed by the World Bank and the International Monetary Fund to reverse the crisis plaguing emerging markets at the time. 

Just as the Global Financial Crisis of 2008 threw monetary policy orthodoxy out of the window, the Covid-19 pandemic has killed off fiscal conservatism. In her latest blog “Continued Strong Policy Action to Combat Uncertainty”, the IMF’s Managing Director Kristalina Georgieva has called on the developed world to increase public spending and avoid what would be a premature withdrawal of the already spectacular policy support. She also recommends a synchronised global infrastructure investment push. The government share of the economy is set to continue to grow all over the developed world. Taxes will need to go higher soon to start paying back all the new debt. That all adds up to lower productivity and, just as importantly, deflationary pressures.

Fig. 2 - Growing burdens
Total debt to GDP ratio, %
Total debt to GDP ratio

Source: BIS, CEIC, Refinitiv. Data covering period 01.01.1970-20.06.2020.

At the same time, economic growth prospects remain muted. The recent trade war between the US and China has stalled the previously long-held trend of globalisation. And it is unlikely that tensions between China and the US are going to fade despite the change of government in the US. Regulation is also on the rise as countries combat climate change – which could lead not only to slower growth but also deflationary pressures.

There are also a number of powerful structural forces that will continue to bear down on both inflation and growth, possibly with even greater force in post-Covid world. These include:

  1. Ageing populations, shrinking workforces: Not only are populations in many countries getting older and baby boomers starting to retire, but the political backlash against immigration in most of the developed world is accelerating the process. With working populations set to decrease and productivity growth remaining lacklustre, real rates of economic growth should remain subpar, keeping interest rates low.
  2. Growing debt burdens: Debt has risen exponentially during this crisis to levels beyond those seen immediately after the Second World War. More resources in the economy are going to be dedicated to repaying this debt, thwarting productivity growth. This will keep a lid on the economic recovery and on inflation.
  3. The continued integration of the emerging world into the global value chain: Even if globalisation may have taken a step back, what we have seen during this crisis is how interlinked our world is and how costly and difficult it will be to go back to protectionism, and to reverse the growing international influence of emerging markets. We might see the reinforcement of regional trading blocs around the US, euro zone and China, but these will include both developed and emerging countries.
Fig. 3 - Fewer workers
Working age population by region, actual and forecast, % of total population
Working age population by region

Source: United Nations World Population Prospects 2019.

The debate surrounding economic policy has shifted; fiscal stimulus will play a bigger role in supporting growth. However, that doesn’t necessarily mean more inflation. And, although growth tends to rise with increases in government spending, such effects tend to be short-lived. 

We would change our minds on the “low for long” theme if at some point fiscal spending is directly financed by central bank money printing, bypassing markets and the financial sector. But, thus far, there are important legal obstacles to doing this in many countries and changing this would take a long time. 

We would also argue that we have not seen enough coordination to warrant caution. The Washington Consensus might be dead, but that does not mean that we are going to move in the exactly the opposite direction. In the US, the assumption that the Democrats will have full discretion in their spending plans is optimistic, in our view. The more centrist segment of the Democratic party opposes heavy fiscal expenditure and tax rises. In addition, the presence of the filibuster process (which requires a 60 per cent Senate majority to pass a law versus a simple majority) means Joe Biden will find it hard to get aggressive spending increases past the Senate easily and may have to rely more on executive orders. In the UK, the loosening of the purse strings by the Chancellor of the Exchequer has not been accompanied by promises that this will continue forever after. In fact, the Chancellor has already spoken about paying for the cost of Covid-19 and freezing wages in the public sector. Over in continental Europe, meanwhile, we have yet to see the implementation of the grand joint fiscal plan, an enlargement of which is not even up for discussion at present.

All of this means that central banks will keep doing the heavy lifting. That means they will continue to offer economic support via quantitative easing and more than cater for the additional bond supply issued by sovereign borrowers. Thus, we believe rates will stay lower and for quite a bit longer!