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The Most Interesting Question in the World?

Updated: May 18, 2022

Here’s an interesting question: do the low or negative long-term real interest rates that prevail around the world signify a bleak economic outlook or are they what is required to stimulate spending and investment, and thus a bright economic outlook?

Governments are worrying about their balance sheets when the clear message from bond markets is that they needn’t"

Both theories are supported by their own coherent reasoning. And yet one of them must be wrong. You cannot have both a bright and a bleak outlook.

Which is correct?

The argument in favour of the suggestion that (low) long-term real bond yields reflect (poor) long-term economic growth prospects is simple. As an economic agent, one has a choice; one can either invest in financial assets, the benchmark of which is a riskless bond, or in the economy via real assets that will provide a return commensurate with broad long-term GDP growth. Theory says that both should track each other. If economic growth falls, bonds become relatively more attractive. As investors buy them, their prices rise and their yields fall, thus redressing the balance.

There are a number of commentators, some more respectable than others, who believe we are about to enter an economic ice age. In other words, they believe that current low or negative real yields do indeed portend a bleak future.

Or do they?

Economic theory also says that the long-term interest rate is the rate required to keep saving and investment in balance. If you want to live within your means i.e. save, you need there to be someone, somewhere in the world, who wants to live beyond his i.e. invest. Oscar Wilde had great disdain for the former, saying “anyone who lives within their means suffers from a lack of imagination.” While one may not like Donald Trump, he, and like-minded individuals who over the centuries have persuaded banks to lend them vast sums should be thanked for helping to boost economic activity and thus prop up savings rates.

It must be infuriating for many that their savings accounts are not yielding much (anything!) at the moment (even more infuriating for those who take inflation into account and realise that their savings are being eroded in real terms). However, these low yields reflect an abundance of those wishing to save and a dearth of those wishing to invest. The best way for savers to get better yields on their savings accounts would be to stop saving and start investing. This would boost the economy, and force central banks to put up interest rates!

The situation is not helped by governments that are worrying about their balance sheets when the clear message from bond markets is that they needn’t. Furthermore, large swaths of sovereign bonds are owned by central banks, and arguably should not be included in debt-to-GDP calculations.

Governments should instead be taking advantage of the low or negative long-term interest rates. As renowned economist Paul Samuelson famously observed, at a permanently zero or sub-zero real interest rate, it would make sense to invest any amount to level a hill for the resulting saving in transportation costs.

To be fair, there are tentative signs that the UK government is getting the message. In 2013 the Treasury issued a 65-year linker with a coupon of 0.125%, receiving a price at auction of 99.37% of par. In March of this year it issued a new tranche of £350 million at a price of 184%. The bonds are currently trading at 249%!

If the proceeds are spent on useful (or even useless!) public works projects, the benefits will be clear. First, there is a multiplier ef­fect attached to public works spending that will boost economic activity well beyond the value of the projects themselves. Second, there will be a boost to private sector confidence. If companies and households see the government stepping in to support the economy, they should themselves be encouraged to invest.

However, it seems to have taken interest rates falling to where they did for the government to have woken from its slumber. In other words, low interest rates are what has been required to stimulate spending and investment and thus secure a rosier outlook.

While both theories about the relationship between growth and interest rates can be argued logically, the debate can be decided once and for all by looking at real world experience. If prevailing real interest rates reflect future economic prospects, there should be a strong and positive statistical correlation between real interest rates and equity returns.

There isn’t.

Regressing forward 20-year real total US equity market returns against prevailing US real bond yields, one finds no correlation at all. In fact, if anything, the correlation is very slightly negative (see chart). This is exactly what one should expect if bond yields tend to do whatever they need to in order to keep growth going.

The implications of this are far reaching. First, one perhaps needn’t be as bearish about the longer term prospects for equity markets as safe haven bond yields suggest one should be. Second, one needn’t be so worried about companies with large pension fund deficits if they are using Gilt yields to discount liabilities, as is common practice. After all, why should a pension fund’s equity holdings be expected to grow in real terms in line with the current long-term real Gilt yield of -1.6% if there is no evidence that they should?

That’s also an interesting question.

Published in Investment Letter, November 2016

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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