In Spain they say that when you turn 50 (age is more of a mental state than a physical one, but that’s another story), you “turn the ham the other way.” For many people, it is a regime change that leads to a different approach to life, a focus on other problems, with sometimes radical changes in behavior, for better or worse. There are similar moments in the economy and markets. Sometimes there are generational changes, what was once important fades into the background, markets change their behavior and economic policy goals shift.
The rapid rise in long-term interest rates observed since the summer shows some elements of such a generational shift. In some ways, it seems as if markets have returned to the days before the 2007 financial crisis. Let’s refresh our memory a little.
At the time, markets assumed inflation was firmly anchored at 2% and gave a negligible probability to whatever happened in the decades that followed: that central banks would cut interest rates to zero and commit to keeping them there for as long as necessary to leave it at zero, or buy government bonds for years. It is true that there has been some discussion about this: in 2002, Alan Greenspan mentioned the threat of “devastating deflation” and discussed economic policy alternatives, and Ben Bernanke, then Fed governor, gave a speech entitled “Deflation: Ensuring That “That’s not happening here.” In fact, the Federal Reserve cut interest rates to 1% in 2003 to minimize the chance that inflation would reach zero. It is also true that Japan had been in deflation for some time, with interest rates at zero and, compared to what central bankers later did, buying government bonds very cautiously. But no one believed at the time that this was possible in the West; It was considered an exotic case due to poor economic management by the Japanese authorities.
At that time, the markets also believed that the equilibrium interest rate was high. For the US, the consensus was that the interest rate that closed the output gap and set inflation at target was around 4-4.25%, which created enough room for rate cuts if necessary – but also created an expected future range of interest rates around this level. Markets can remember that the Fed raised interest rates to 6.5% in 2000. It is therefore not surprising that in 2006 the markets had already priced in that the short-term interest rate would be around 5% five years later (i.e. in 2011). Something that didn’t happen, because in 2011 interest rates had fallen to zero, but that’s another story.
The current trend in long-term interest rates implies a return to the pre-2007 crisis. Markets expect that inflation will be firmly anchored at 2% over the next decade, the equilibrium interest rate will be positive and central banks will no longer raise interest rates reduce it to zero or buy bonds. For example, the markets assume that the short-term interest rate in the USA will be around 4.5% in five years (i.e. in 2028). The markets appear to have completed the deflation phase.
Why this regime change? It is difficult to pinpoint a single factor, but there are several clues. On the one hand, the difficult fiscal situation in the USA, with a budget deficit of 6% of GDP and low expectations of a reduction in this deficit, given the institutional instability and the fragility of the budgetary process. The prospect of large deficits – the Congressional Budget Office predicts deficits of over 5% of GDP over the next three decades – has increased the risk premium for long-term bonds. The law of supply and demand also applies to government debt: given the expected ample supply of government debt to finance these deficits, investors demand a lower price to purchase it (which implies a higher interest rate).
On the other hand, the expectation that Japan could abandon the zero interest rate regime after almost four decades (with a very short interval in 2005-2006 when interest rates rose to 0.5%). Japanese investors are major buyers of global government bonds, and a rise in interest rates in Japan to 1 or 2% would therefore change the pricing structure of government bonds worldwide. It is also becoming increasingly clear that the global economy is more resistant to interest rates than previously assumed. After a very aggressive rise in interest rates and despite an unprecedented energy shock, the global economy has the best labor market in recent decades: according to OECD data, the employment rate of the G7 countries is the highest in history.
There are other factors that are perhaps more speculative. For example, that in the future supply shocks will be more prevalent and inflation will be more volatile, for example due to climate change and geopolitical uncertainty, and that bonds will therefore be less useful as a hedging tool for investment portfolios – as inflation shocks increase the likelihood that this will happen Interest rates will rise and stock prices will fall at the same time. And if bonds are less useful as a hedging instrument, their price should be lower – that is, their interest rate should be higher. It is also true that equity markets have resisted rising interest rates well, suggesting that the rise in interest rates may be partly due to better medium-term growth prospects.
Journalism is always the first draft of history. It is possible that in a few years we will look back and conclude that the cumulative effect of the reforms and policies developed in response to the 2007 financial crisis, the euro crisis, the pandemic and the rapid rise in energy prices helped to improve the economic policy framework, restore the health of the global economy and end the deflationary cycle that began in 2007. Let’s not forget that a world with positive interest rates and inflation is better than a world without interest rates and inflation. Just as many people reach their peak in their fifth decade of life and “turn the ham the other way,” it is possible that the economy in the coming decades will be better than it was in the previous two decades. Let’s celebrate it and take advantage of the opportunities.
On X @angelubide
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