Debate has been frenzied this week about how fast the US Federal Reserve plans to raise interest rates. But as investors look forward, it is also a good time to glance back and ask why rates have been so low this decade.
Conventional wisdom usually blames two factors: first, central banks such as the Fed have deliberately pushed down policy rates with startling quantitative easing experiments; second, rates have been depressed by the curse of “secular stagnation”, the phrase coined by Harvard economist Lawrence Summers.
More specifically, Mr Summers and others argue that the global economy is suffering from a stark structural decline in aggregate demand. Thus low (or negative) market rates are a consequence and a signal of collective investor forecasts about future economic gloom; or so this narrative goes.
But could this secular stagnation explanation be completely wrong? That is the provocative idea that Hyun Song Shin, economic adviser at the Bank for International Settlements, floated in a speech. Most notably Mr Shin and many of his BIS colleagues think we are misguided to believe in that “signalling” power of low rates, or blame them on secular stagnation fears.
This argument has not attracted much attention, partly because of that frenzy about higher rates. But it should. For if Mr Shin is correct in his argument (and I think he is), this has implications for how the Fed’s actions might shape markets in the future as well.
Mr Shin believes that modern economists have a crucial blind spot: they tend to ignore how the financial system really works, since they operate with idealised models of money and investor incentives.
This is not a new problem. On the contrary, the BIS has argued before (again correctly) that it was one reason why so many policymakers failed to see the looming financial crisis: before 2008, economists did not see the danger signs emerging in the weeds of financial markets, such as credit derivatives, because they were trained to watch only “real” economy signals (such as inflation).
After that crisis hit, central bankers briefly seemed to change their ways. But Mr Shin fears that this blind spot is returning again: most notably, economists tend to blame low rates on the real economy, instead of looking in the weeds of finance.
“Long-dated yields may be overrated as a forward indicator of economic conditions,” he writes. “Far from being a window on the future that reveals insights that no individual market participant has, low yields may, instead, reflect very ordinary motives of individual investors.”
By way of illustration, he points to the collapse of long-term euro bond yields between 2014 and 2016. When this happened, it was widely interpreted as a sign that investors were gloomy about future eurozone deflation and recession. However, the BIS studied German life insurance companies, which have recently accounted for 40 per cent of government bond purchases, and concluded these were gobbling bonds not due to deflation forecasts, or an enhanced appetite for risk.
Instead, “accounting rules and solvency regulation” forced insurers to match assets to liabilities. And due to kinks in how these rules work (too complex to spell out here) insurance groups felt compelled to buy more bonds to hedge their risks when yields fell, even though this upended normal investment logic.
The result was a bizarre, self-reinforcing feedback loop that traders describe as “negative convexity” (and George Soros, the hedge fund manager, calls “reflexivity”).
This sounds geeky. But it has two implications. It suggests that western central banks may have been misguided to keep rates so low for so long; instead of curing economic gloom, quantitative easing may have reinforced market unease by making insurance companies and others behave in perverse ways.
It would also be foolish to assume that the future trajectory of rates will be smooth and gentle - never mind that Fed “dot plot”. As Mr Shin notes, “the amplification mechanism” that pushed yields lower could equally work in reverse”. Fed rate rises might unleash new feedback loops, pushing market rates much higher than expected, echoing the pattern seen, say, in 2004.
That has certainly not occurred yet; on the contrary, 10-year Treasury yields fell after this week’s Fed rate rise. But investors should not ignore the threat of a reverse “amplification mechanism”, particularly given how overleveraged many entities have quietly become in recent years. Including inside the American government.