In line with the unfolding economic recovery, bond yields started to edge up in late 2009. Markets are discussing how long central bank rates can stay at their post-Lehman record lows. But how much will interest rates and government bond yields have to rise in the post-recession era? And what could this mean for corporate financing costs? To address these questions, we first have to look at the major trends that shaped the global economy in the past decade.
The Rise of Emerging Markets
The dominant long-term trend has been the rise of major emerging markets. Never before have so many people escaped abject poverty so fast than in the first decade of this century. For simplicity’s sake, let us focus on the most spectacular example: China. Once China started to offer minimum economic freedoms, it developed in a fairly familiar pattern. The first priority for people moving from a precarious existence to a more regular income is not to buy more but to save more, so that a setback in life would not throw them back to the edge of starvation. Emerging economies enter the world market first as producers, not as consumers, as exporters, not as importers.
Taking its cue from the currency turmoil of the Asian crisis in the late 1990s, China also pegged its currency to the US dollar at a rate that made Chinese exports artificially cheap. As China accumulated its excess savings as foreign exchange (FX) reserves, it invested them mostly in dollar-denominated bonds. This kept bond yields artificially low in the US and elsewhere in the western world. Cheap financing helped to spur a surge in debt in the US and some other countries as the mirror image of the surge in assets in China and some other emerging markets.
However, export-driven growth cannot continue forever. As memories of dire poverty fade and hundreds of millions of urban Chinese become accustomed to regular and rising incomes, they start to look for the good life, spending more and saving less of any extra income. Retail sales in China have expanded at rates well above 10% for the past five years already. Over time, the rise of the Chinese consumer will suck in more imports and slow down the growth in exports, as more goods and services are used at home. In addition, safeguarding the real value of consumer savings will turn into a bigger domestic priority. To achieve that, China will most likely let its currency appreciate again shortly.
As China consumes more and allows its exchange rate rise, its exports will exert less downward pressure on prices in the western world. In the same vein, its inflow of FX reserves will slow down. Previously, Chinese exports of goods and capital had helped to keep inflation and interest rates down in the west. These factors will become much less important in the years to come. On its own, this should lead to higher interest rates and somewhat less subdued inflation in the western world.
Beyond the China Factor
Beyond the China factor, two other major trends had shaped the global interest rate environment in the past two decades. First, most western governments had managed to get their fiscal deficits under control in the 1990s. Although the often-criticised Maastricht criteria to qualify for monetary union were sometimes bent or observed in the breach in western Europe, they helped to instil some extra fiscal discipline in continental Europe. In the US, President Clinton and Congress achieved a similar feat. Some countries, for example the US in 2000 and Germany in 2007, even managed to balance their budgets or run a small surplus. Less government borrowing also helped to keep bond yields and overall interest rates down.
Second, central banks in the US and some other countries overreacted to the decline in inflation caused partly by China. Sensing a risk of deflation in the wake of the mild recession of 2001, they slashed their central bank rates to very low levels, with the US Federal Reserve taking the lead by keeping its funds rate at a mere 1% from May 2003 to June 2007.
As these three factors (Chinese surplus savings, very low US Fed rates and restrained fiscal deficits) came together to push private sector financing costs to unusually favourable levels, private sector debt boomed. This fuelled a housing bubble in the US, the UK and Ireland among other places. It also encouraged a rapid expansion of leverage. Non-financial companies used cheap debt to buy back equity and thus inflate their stock price; banks offered and loaded up on highly geared products to take advantage of cheap funding. While it seemed to make perfect sense at the time, it made the economic and financial system more vulnerable to shocks.
Of course, all excesses need to be eventually corrected. Following rate hikes by the Fed and other central banks, the US real estate market started to turn down in 2007. The financial reflections of this process, notably the calamities caused by rising default rates on sub-prime debt, made the financial system even more vulnerable at a time when a temporary surge in oil prices helped to push western economies into stagnation in mid-2008.
When the failure of Lehman brothers sparked a panic, the mostly orderly correction of excesses turned into a rout. Trying to improve their liquidity positions in a rush, companies around the world slashed business investment and other non-essential purchases. As a result, world trade and business investment in the western countries plunged much faster than at any time since the Great Depression. Those economies specialising on the production and export of investment goods, such as Germany, Japan and Sweden, suffered a much deeper recession than the US, although they had none of the problems with real estate or consumer debt that the US had.
The tide started to turn when the Fed signalled in early March 2009 that it would do everything – repeat everything – to get the financial crisis under control. As the risk of wholesale nationalisation of major parts of the banking system faded, market confidence started to return, followed by an improvement in business sentiment. Generous fiscal stimulus programmes also helped to stabilise demand.
One year on, the west finds itself in a situation in which interest rates and inflation are very low while budget deficits are extremely high. In the US, the rise in public deficit has exceeded the increase in household savings by a factor of three.
Until late 2009, the avalanche of new public debt issues seemed to have no impact at all on yields for government bonds. In the US and the UK, the central banks absorbed more than the entire net increase of US Treasury bonds and gilts by buying this paper in their programmes to expand their balance sheets (quantitative easing). Safe-haven flows into the relative safety of government bonds had even pushed yields to record lows last year. But as the economies recovered and central banks ended some their asset purchase programmes, yields started to edge up, only to drop again as concerns about the fiscal position of Greece spooked markets and triggered some new safe-haven flows into the bond markets of the US and Germany.
Bond Yield Drivers
Let us look at the major factors that could determine bond yields and private sector financing costs in the years ahead.
Fiscal deficits are likely to stay elevated for years to come. Making room in the public budget to pay the interest on the extra debt incurred during the crisis will be a major challenge for many countries. More supply of government bonds will tend to push bond yields up.
Central banks cannot keep their interest rates at rock-bottom level for much longer. Rates of virtually zero (Fed), 0.5% (Bank of England) or 1% (European Central Bank) were emergency measures that made sense when the patient needed intensive care. But as the patient moves into rehabilitation, the dose of the potent medicine needs to be reduced. We predict that central banks will start raising rates within the next 12 months, probably with the ECB first (June 2010), followed by the Bank of England (November 2010) and the Fed (March 2011).
Short-term inflation risks are very subdued. As unemployment is high and capacities are used much less than normal, demand and output can increase without hitting serious inflationary bottlenecks in the western world. A major consumer boom, which could spark domestic inflation, does not seem to be on the cards for years to come. As a result, central banks do not have to be proactive. They do not have to slow down growth. Instead, they can normalise interest rates gradually, responding to continued financial healing and better economic data as they unfold.
The long-term inflation outlook is less benign, though. First, the period in which the western countries could, to some extent, import price stability from China is drawing to a close. Second, the fiscal legacy left by the post-Lehman recession can add to inflation in two major ways. Taxes may have to be raised over many years in many countries, particularly in those such as the US, the UK, Ireland and Spain in which the ratio of public debt to gross domestic product (GDP) has skyrocketed since 2007. To the extent that sales taxes, other indirect taxes or charges for public services go up, prices will rise directly. In addition, a higher tax burden typically creates economic distortions. This reduces the pace at which economies can expand without hitting inflationary bottlenecks. Until demand management has adjusted to the slower expansion of potential supply, the net result can be a modest increase in the underlying trend rate of inflation. In the very long run, however, a reduced pace of trend growth can also dampen the rate of loan demand growth. In turn, this could weigh on bond yields.
In many respects, the western world is facing a return to the situation that prevailed in the early to mid-1990s, before the spectacular rise of China and before markets had become used to lower inflation and lower fiscal deficits. Once economies have meaningfully recovered from the post Lehman-crisis, and unemployment and rates of capacity utilisation have returned to normal levels – or once the market expects this to happen shortly – inflation risk premia are likely to rise. Such risk premia can be a significant part of inflation-adjusted real bond yields.
In the end, the world will have to get used to somewhat higher nominal and real bond yields again than those that prevailed between 2001 and 2009.
However, we should not exaggerate the potential upside for bond yields and inflation. Some observers worry that governments will try to simply inflate away their debt burden. We do not see this as a serious risk. First, central banks in the west are independent. While their precise degree of inflation tolerance may vary over time, they are unlikely to take orders to deliberately engineer a major surge in inflation. Second, higher levels of government debt do not translate automatically into additional inflation. Abstracting from volatile import prices, consumer price inflation takes off when a boom in final consumer demand vastly outstrips the available supply for goods and services for consumers. But consumers in the US, the UK and some other countries will likely want to rebuild their savings for years to come. We expect a significant overall economic recovery, but a consumer boom that could turn genuinely inflationary seems highly unlikely.
Of course, central banks could make a mistake and keep policy far too expansionary for far too long. But as capacities are currently underutilised, central banks would have more time than usual to notice that the economies are growing much faster than expected before growth could turn inflationary. Central banks could correct any such mistake well before inflation could become entrenched. Even for governments, the incentive to simply inflate away the extra debt is not clear-cut. As we learned in the late 1970s, inflation can become deeply unpopular. High rates of inflation, say of 4% and above, are not necessarily a vote winner, and thus not really an easy option for politicians seeking a return to office.
Outlook for Corporate Risk Premia
The market turbulences of the past two years have been a stark reminder as to how potent risks can be. Seen with hindsight, the compression of risk premia at the height of the search for yield, driven by artificially low interest rates in the years to 2007, went too far. Such minimal spreads are probably gone for good, or at least for as long as memories of the recent turmoil are still fresh. However, as the global economy recovers, the fundamental outlook for most companies should stay positive. As a result, we expect only a modest widening of corporate yield spreads over coming years.
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