8/9/2019 Barclays2CapitalDavidNewtonMemorialBursary2006Mart

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BARCLAYSCAPITALDAVIDNEWTONMEMORIALBURSARY2006

Why are long-term real interest-rates so low and does it matter?When the Inverse Plague Explains the Conundrum of

Low Long-Term Interest Rates

Do China and other emerging markets hold thekey to solving the persistent low long-terminterest rates conundrum, famously dubbed

by Alan Greenspan? The former Fed Chairmanwas speaking to an apparent paradox: despiteseventeen consecutive nominal short-run ratehikes by the Fed since June 2004, U.S. long-term rates have remained unmoved. In fact,U.S. nominal long-term rates have trended wellbelow their historical two-percent premiumover short-term treasuries. As a result, even asinflation has edged up, long-term rates havefallen, flattening and even inverting the U.S.

yield curve.

Just as the Black Death of the 14th centurydrove up inflation by decimating a third of

Europes working-age cohort, todays swellingformal workforce in emerging markets acts asan inverse plague, expanding the labour pool,moderating wages and dampening long-runinflation expectations.

Surprisingly, this tremendous productiveimpetus has failed to take centre stage as alikely explanation for the conundrum. Instead,many believe that the low long-term rates areill-omens for the global economy, anticipating agloomier growth scenario than the consensusforecast. Others argue that the bond market

has overshot; forgetting that the global creditmarket is extremely liquid and investors wouldrush in to arbitrage away any misalignment insecurity prices.

The explanation which has gained the mostcurrency, however, is Ben Bernankes savingglut theory. Bernanke argues that excessiveinternational savings is holding down long-term

rates. Faced with limited investmentopportunities and wary of stagnant growth inEurope and Japan, foreign investors are

funnelling capital into the U.S. Treasuries. They are being accompanied by emergingmarket central banks, which are accumulatingreserves hand over fist to prevent anappreciation of their currencies.

Bernankes savings glut conveniently shiftsresponsibility for the U.S. current and fiscaldeficits from American profligacy to foreignabstemiousness. But global savings andinvestment levels are not yet sporting the signsof a glut: relative to output, both are belowhistorical averages (Figure 1). Also, the bulk of

U.S. securities held by foreigners isconcentrated in the short end of the curve, withlittle effect on long-term rates. Furthermore,the conundrum is a global phenomenon,affecting Europe and Japan even if they are atdifferent stages of the business cycle anddespite the different structures of theireconomies.

Looking to the U.S. economy, in a reversal fromthe 1990s, corporate America is awash in cash.Fuelled by improved productivity (from the techera), declining capital-goods prices, andconsistent profitability, U.S. corporate savingshave offset half of the recent increase in U.S.government and household borrowings. Theseaccrued earnings may be keeping long-termrates down, but even this is far from certain:only a portion of corporate savings has beenchannelled into securities. The rest has beenused to clean up balance sheets andaccumulate equity either through sharerepurchasing or direct investment abroad.

8/9/2019 Barclays2CapitalDavidNewtonMemorialBursary2006Mart

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The Inverse Plague and the Low Long-Term Rates Conundrum 2

The notion of either a domestic or foreignsavings glut keeping long-term rates down isonly a partial explanation at best. Perhapsmost critically, the savings glut argument, byfocusing on international capital flows only,tries to solve one paradox by raising another:

why have inflation expectations remained low

with strong consumer demand, high capacityutilization and rising commodity prices?

This is all the more puzzling considering themassive amount of liquidity that central bankssent sloshing around the world economyfollowing the tech bubble in 2001. But sooneror later one should normally see nominal long-term rates rise to preserve real return againsthigh commodity prices and inflationexpectations. Yet, both current and expectedinflation have remained subdued, as have long-term yields.

The answer lies in the globalization of goodsproduction and trade. Inflation results from toomuch money chasing too few goods, but when

excess liquidity accompanies greater globaloutput, the conundrum becomes less of ariddle. Indeed, liberalized trade has stokedcompetition and dampened prices (Figure 2) byallowing mature markets to tap the excesslabour force of emerging markets to procurenot only greater quantity and quality goods,

but services as well. In China alone more than200 millions have joined non-agriculturalsectors since 1987; accounting for half the

workforce and rising (Figure 3). If Sir ArthurLewis two-tier model of economic developmentholds true, this migration toward non-agriculture avocations will continue to act asan immense buffer against inflation. The worldeconomy has never welcomed in its midst somany so fast. This is the age of the plagueinverted, less a conundrum.

Martin Philibert