Getting used to the new normal

“Any rebound to ‘normal’ looks weak right now,” says Dov Zigler, financial markets analyst with Toronto-based Bank of Nova Scotia in New York. His view: “Central banks have a mission to hold long-term interest rates down. We would be worse off if real interest rates were to rise.”

The explanation for today’s low sovereign bond yields is that the global economy remains weak, with growth the slowest it has been since 2009, and global political instability. There is also, of course, quantitative easing by the European Central Bank and the U.S. Federal Reserve Board, as well as many other central banks; those policies continue to flood the markets with cheap money.

It has the look and feel of policy written to overcome a crisis of confidence, yet, in other major crises, government bond yields remained positive. From 1900 to 1989, for example – despite two world wars, the Great Depression, regional wars in Korea and Viet Nam, and numerous revolutions – the coupons on long Government of Canada bonds never dropped below 2.93%, which was the rate from 1940 to 1949. U.S. long bond yields never fell below 2.31% – that was in the 1950s. Even in the 1990s, U.S. long treasuries averaged 10.38%.

What makes today’s rates exceptional is not only central bank policy designed to hold the short end of the yield curve down, but quantitative easing that has raised bond prices and forced down yields. The world is awash in money.

With investment-grade corporate bond yields tumbling and closing the yield gap on government bond yields, central banks are watching the entire term structure of interest rates decline. Bond investors are buying sovereign debt with low or negative nominal yields as costly insurance against crises yet to come. Paradoxically, further declines in interest rates will push up prices of existing low-interest bonds.

Investors in low-yield senior corporate debt are swapping mild credit risk for the high-duration risk of sovereigns, presumably understanding that if rates do start to rise, negative and very low interest long bonds will undergo a swift and bloody sell-off. Moreover, with the bond bull market having run for 33 years with few reversals, a decline in bond prices is inevitable. Every other levitated asset class, from commodities and stocks to land and, of course, tulips eventually returns to earth.

The question is, when will the inevitable happen to bonds? It could be when the Fed’s rate-setting Open Market Committee makes its pronouncements on Sept. 21, but the market, at the time of writing, thinks it unlikely.

Sal Guatieri, senior economist at Toronto-based BMO Nesbitt Burns Inc., foresees the long-term forces that are holding rates down persisting for many years.

“We do not see interest rates returning to their former norms, even when the world economy returns to health,” he says. Guatieri’s argument: the supply of loanable funds is high because of quantitative easing, which pumped up bank reserves. But the glut of investible money seeking security in sovereign debt means the price of money – i.e., interest – is low to negative in the most prized of sovereign issues.

Put another way, there is an ocean of money seeking haven in a few islands of rock-solid sovereign debt. With inflation low in most countries, investors neither seek nor are compensated for rising prices.

“Central banks around the world pumped up money supplies and created vast reserves of loanable funds,” Guatieri explains. “Central banks continue to buy assets and print money. Inflation is low, and that adds to pressure to keep interest rates low. Unemployment remains high in much of the world, especially in Europe, adding to pressure to hold interest rates down.”

There is also a bonus for governments and their central banks when they maintain interest rates below inflation. Governments pay a pittance to carry their debt, then watch inflation wipe out that cost. This strategy amounts to governments defaulting on their debt without having to admit doing so.

Government bond yields that are low or negative are also the consequence of high liquidity preference. In the short term, investors buy major nations’ sovereign debt as a safe haven in a time of incessant warfare in the Middle East, Brexit, further declines of the pound sterling and the euro if other countries decide to leave the EU, and uncertainty regarding the future of the U.S. In the long term, major nations’ populations are not growing. Fewer families forming means less borrowing for new homes, as well as lower aggregate investment and borrowing.

But trends are temporary. It follows, says Edward Jong, vice president and head of fixed- income at TriDelta Investment Counsel Inc. in Toronto, that when global risks abate, economic growth rises, inflation rises by a per cent or two, and demand for loanable funds increases, interest rates will follow. Nobody predicts any of that will happen soon.

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