Why interest rates will be higher for longer

Where are interest rates heading and why?

What does history tell us about interest rates?

Even though bond yields have pulled back from their 2023 high points, they remain elevated compared to their level in the decade between the European debt crisis and Covid; a period where the central banks of developed economies universally took policy rates to zero and engaged in quantitative easing (QE). Over that decade, US nominal and real 10-year bond yields averaged 2.2% and 0.3%, respectively, and despite policy rates being at zero and the global economy awash with liquidity from QE, central banks struggled to stabilise inflation expectations at their targets.

Currently, US nominal and real 10-year bond yields are priced at 4.1% and 1.8%, respectively. What is an appropriate level for nominal and real long dated government bond yields? Is it closer to the average of the last decade or closer to current market pricing?

We argue that it’s closer to current market pricing. Why so? And if this is the case, how do we explain the levels of interest rates over the last decade?

In the three decades prior to the GFC, following the application by central banks of inflation targeting, US nominal bond yields averaged 5.8%. Over the same period, US nominal GDP growth averaged 6.0%. Inflation averaged 3% and the US economy’s real growth rate averaged 3%.

Although we don’t have data going back to 1989 for real and nominal bond yields, since data is available, from 1997 to 2008, US 10-year nominal bond yields averaged 4.9% and real bond yields averaged 2.9%. Over the same two-decade period, the growth rate in US real GDP averaged 3.0% and inflation averaged 2.1%.

For developed economies such as the US, the very close concordance between nominal bond yields and nominal GDP growth rates and real bond yields and real GDP growth rates (and by inference, between inflation and break-even inflation rates) is not by accident.

If national income growth was to persistently exceed interest rates, the nation’s capacity to repay debt would exceed its repayment burden and either debt would fall to zero over time or the nation could maintain a constant debt-to-income ratio by constantly borrowing, which, of course, is the definition of a Ponzi scheme.

Market forces react to the shifts in the demand for funds and interest rates adjust to ensure that balance is generated between demand and supply, on average, over the longer run.

The anomalous decade

The years between the GFC and Covid, and particularly the decade following the European debt crisis, was a period of trauma for central banks. The loss of confidence that enveloped households, governments and investors threatened to drive the global economy into deflation with a very real threat of depression.

To avoid deflation, and a catastrophic slide in inflation expectations, central banks across the globe took policy rates to zero and injected enormous amounts of liquidity into the financial system ensuring that asset prices did not collapse. These policies persisted through to 2020, with the initial onslaught of Covid.

During this decade of interest rate suppression by central banks, US nominal GDP growth averaged 3.8% and real GDP growth averaged 2.3%. These growth rates are significantly higher than 10-year nominal bond yields (2.2%) and 10-year real bond yields (0.3%), which is anomalous to the previous 20 years and what we would expect the long run relationship to be between interest rates and economic growth.

A consequence of this differential was that low interest rates (particularly low real interest rates) made it difficult for institutional investors to meet their return targets (typically of inflation plus 4%) with the standard 60/40 portfolio; i.e., 60% share of growth assets and 40% share of defensive assets. This sparked the so-called search for yield, based on the assumption of “lower (interest rates) for longer”. Despite ongoing threats to economic growth, and the struggle with driving inflation back to central bank targets, investors shifted preferences towards risk assets emboldened by a central bank policy that had the effect of shoring-up of asset prices.

A diminished risk of capital losses encouraged further the shift to more risky assets and institutional investors began moving away from the traditional 60/40 portfolio to a higher weighting to growth/risk assets. For as long as central banks had difficulty in convincing investors that they would be able to consistently shift inflation back to their target band, increasingly, investors began assuming the lower-for-longer scenario to be the central case.

Covid changes everything

The lower-for-longer paradigm was shattered by Covid. There are three key reasons for this:

1. the combination of supply-side bottlenecks and incredibly loose fiscal and monetary policy during the period from 2020 to 2021/22 created the excess demand conditions resulting in a burst of inflation not experienced since central banks had tamed the inflation genie of the 1970/80s;
2. during the period of reflation, central banks stood on the sidelines and cheered as long run inflation expectations climbed gradually towards their targets after having slumped to their lowest levels since the GFC. This meant that central banks were not only slow to raise interest rates to control inflation, but it also signalled to markets a tolerance by central banks to allow inflation to rise above target; and
3. finally, governments came under little pressure to lower debt levels blown out by the income support schemes implemented during Covid. This is in stark contrast to the post-GFC experience when the European debt crisis threatened to spread to other debt-laden economies and regions, forcing most governments to adopt stringent fiscal austerity policies. With fiscal policy as a structural headwind to economic growth in the post-GFC decade, it is not surprising that pessimism over the economic outlook prevailed. In the post-Covid era, markets appear to be far more tolerant of government debt levels, allowing fiscal policy to play a more active role in the stabilisation of economic growth.

The upshot has been a stabilisation of long-term inflation expectations close to or at central bank targets, with risks more evenly distributed to the upside and downside than was the case in the decade between the GFC and Covid, where central banks failed to stabilise inflation expectations at their targets and where risks were skewed to the downside.

The implication for monetary policy is that the days of zero policy rates and QE are now likely to consigned to the dustbin of history. Without the suppression of interest rates by central banks and with inflation expectations stable and close to central bank targets, markets will once again shift rates to be closer in-line with economic growth.

The future for interest rates

So, where will interest rates be heading? Let’s consider the US, the dominant global market.

If we are correct about interest rates and growth rates re-establishing their historical relationship, then the key to understanding the secular trend in interest rates is understanding the secular trend in economic growth. QIC Economics & Research are currently conducting an extensive review of potential economic growth rates across global economies and economic regions.

We use a methodology based on the way that labour and capital combine with technology to generate productive capacity. This involves projecting labour force growth, secular trends in productivity and rates of return to capital.

In the case of the US, we estimate that the potential (trend) average annual real GDP growth over the coming decade to be around 1.8%. This is composed of trend employment growth of 0.5% and trend labour productivity growth of 1.3%. Of course, this is lower than historical averages, reflecting the downward trends in both demographics and productivity.

Over the next decade, if we assume that central banks maintain their recent success in managing inflation expectations at around their targets, then we can expect such expectations to average around 2.3% in the US (based on the CPI which would be equivalent to 2% on the Fed’s PCE inflation target).

Combining our forecasts for inflation expectations and real GDP growth, we would expect nominal and real yields on US 10-year bonds to average around 4.1% and 1.8%, respectively.

Implications

For financial markets, the obvious conclusion is that it raises the hurdle rate for investments in growth/risk assets, such as equities, and raises the long term returns to defensive/safe assets, such as fixed income assets. The implication is that we see a reversal of the search-for-yield strategy that dominated the later years of the post GFC/pre Covid period, a reduction in portfolio duration and increased competition over the return offered to clients by superannuation funds.

For economies, the real interest rate environment should also increase businesses hurdle rate for capital expenditure (the “real economy” analogue of the “financial economy” increase in the hurdle rate to invest). However, given that the hurdle rate to capex did not follow real interest rates lower during the post-GFC decade, perhaps we will see a compression of the spread between businesses’ hurdle rates for capex and real interest rates rather than a lifting of the hurdle rate.

For governments, the closing of the gap between GDP growth and interest rates has the effect of closing the gap between the rate of increase in government revenues (that are tied to the rate of economic growth, such as income and profit taxes) and the rate of increase in interest payments on debt. In a world where many major economies, including the US, are running large government debt/GDP ratios, this may well lead to severe limitations on fiscal policy over the coming decade.

If interest rates and growth rates come back into parity, the only way to stabilise government debt in the long term is to run a primary budget balance; that is a balanced budget after the exclusion of interest payments on government debt. This would be a very large task for many governments that are currently running sizeable primary budget deficits and could lead to government fiscal policy entering, yet again, a period of sustained structural constraint.