Pondering Interest Rates

Apr 28, 2023

As a recovering Wall Street economist, the scars of my interest rate prognostications have taken the longest to heal. So, take what you are about to read with more than the usual grain of salt.

First, the easy part: It seems reasonably sate to conclude that the secular decline in interest rates is over. Real (inflation-adjusted) interest rates on 10-year US Treasuries stood at 8.4% in 1982 when I first went to work at Morgan Stanley. [1] The steady, unrelenting descent from that peak could have well been the most powerful force supporting a broad range of asset markets—equities, real estate, commodities, and most credit instruments.

By 1992, this measure of real long-term interest rates had plunged to 3.7%, less than half the peak rate ten years earlier. Then the “great moderation” took hold and real rates averaged just 2.4% for approximately two decades from 1992 through mid-2011—an astonishing six percentage points below the peak levels of 1982. Notwithstanding the roller coaster ride of several major crises during that period—the Asian Financial Crisis of the late 1990s, the dotcom crisis of 2000, and the Global Financial Crisis of 2008-09—the great moderation was nirvana for those of us on Wall Street at the time.

Alas, there was more to come. A second phase of the great moderation saw real long-term rates fall to an average of just 0.5% from mid-2011 through 2019. The wheels then fell off during the Covid shock, when real long-term rates fell into negative territory, plunging to a low of -0.7% in September 2020. Currently, these rates stand at 1.6%, essentially midway between the two distinct phases of the great moderation noted above.

Now the harder part: What comes next? My hunch is that real long-term interest rates stand a better chance of reverting to 2.5%—the upper end of the great moderation range—rather than falling back to the lower end of that range at 0.5%. Three reasons:

  • First, the world is about to shift from surplus saving to saving absorption. Importantly, this should reflect rising military expenditures associated with a new global focus on security—not just an outgrowth of a worrisome US-China superpower conflict but also a reflection of the war in Ukraine, which is having a comparable impact on European defense spending; moreover, China’s muscularity is having a collateral impact on defense spending elsewhere in Asia—especially Japan, Korea, and, of course, Taiwan. Couple that with a ramp-up of infrastructure spending, the golden era of the saving glut is over.
  • Second, the world is shifting from globalization to de-globalization. There is intense debate over this point, but I believe we will look back on the Global Financial Crisis of 2008-09 as the peak of the modern globalization cycle. Some have dubbed the post-GFC period as “slowbalization”—a clever way of fudging the debate, by arguing that globalization is continuing, but just at a slower face. However, with the global trade share of world output flattening out and foreign direct investment falling as a share of world GDP, the key metrics of globalization say otherwise. This shift, whatever you want to call it, reduces supply relative to demand—driving real interest rates higher.
  • Third, it is no accident that the secular decline in real long-term interest rates was joined at the hip to an equally powerful secular disinflation. For a variety of reasons, including the first two points above, there is good reason to believe those days are behind us. As I wrote recently, superpower conflict is inflationary, as is the de-globalization that fragments heretofore dis-inflationary supply chains. Other reflationary factors to consider: the excess liquidity that central banks will ultimately fail to withdraw from the financial system, a shift from capital to labor as many nations face the pressures of inequality, and a persistent weakness in productivity.

Financial markets are currently priced for a return to lower rates following the back-up of the past year—a very different scenario than the one I have sketched out above. But don’t forget, as I said at the outset, take this all with a grain of salt.

You can follow me on Twitter @SRoach_econ

[1] This metric is calculated as the nominal yield on 10-year Treasuries less the Cleveland Fed’s gauge of inflationary expectations; by using this survey-based measure of forward-looking price expectations it is, thus, an appropriate ex ante gauge of real rates. It is taken from Chapter 4 from the IMF’s April 2023 World Economic Outlook.

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