The future of interest rates is more surprises

LONDON, Nov 24 (Reuters Breakingviews) - Central bankers and market practitioners were clearly wrong-footed by the recent rise in interest rates. “Lower for longer” was the mantra until a few years ago. Then came “higher for longer” and now possibly “lower slightly sooner than expected". Observing these oscillating forecasts, a bystander might conclude that nobody knows anything about the future direction of interest rates. And that’s how it is.

Two years ago, the U.S. Federal Reserve’s interest-rate setting committee projected that the federal funds rate would be in the range of 1.1% to 2.1% by 2023. Today the rate is above 5%. Central bank models attempt to divine what is known as the natural or equilibrium rate of interest: the level that allows an economy to reach its growth potential without sparking inflation. After the financial crisis of 2008, inflation disappeared and economic growth slowed, so the models concluded that the natural rate had dropped.

The return of inflation caught those models by surprise. Now they have recalibrated. A recent report from Capital Economics suggests that the U.S. equilibrium rate has risen from 0.5% before the pandemic to 2% today. The London-based research firm believes that artificial intelligence will boost future GDP growth, while increased government borrowing and the energy transition are set to absorb more savings. Some economists argue that the retreat from globalisation will also push up interest rates. Such plausible narratives are ad hoc rationalisations of recent movements in interest rates rather than a reliable guide to where they are heading.

A few years ago, the economist Claudio Borio and his colleagues at the Bank for International Settlements critiqued the models used by monetary policymakers. These models, they said, assume that real interest rates are determined exclusively by economic factors such as the amount of slack in the economy, demographics, inequality and other influences on savings and investment decisions. By contrast, the models assume inflation is a monetary phenomenon, set by central bank policies.

The study examined data from 19 countries back to 1870 and found only a tenuous link between the determinants of savings and investment and real interest rates. “No single factor or combination of such factors”, the authors concluded, “can consistently explain the long-term evolution of real interest rates. This holds true at both the domestic and global levels".

The reason for this failure, Borio suggests, is that conventional theory has things back-to-front. Inflation is driven by real factors, whether supply chain disruptions, strikes or sectoral shifts, while the real interest rate is primarily a product of where central bankers themselves set interest rates. It is a controversial claim. But it would certainly explain why central bankers' forecasts seem to track their own policy gyrations so closely.

Professional fixed-income investors have not done much better. Over the past couple of years, they have suffered mark-to-market losses worth trillions of dollars by holding bonds at prices which reflected expectations that rates would stay low indefinitely. In the summer of 2021, the Austrian government issued a 100-year bond with a coupon of 0.85%. Within a few months, the bond had traded up to 139 euros. By last month, its price had fallen by around three-quarters from this peak. So much for the wisdom of crowds.

Bond investors deserve some sympathy, however. In the stock market, high valuations usually lead to lower future returns. By contrast, bond markets do not revert to the mean over any investible period. In recent decades, speculators lost their shirts selling short Japanese government bonds which, at the time, yielded only a handful of basis points. Ultra-low rates persisted so long in Japan that this trade became known as the “widow maker”. No wonder investors failed to anticipate the recent upturn in rates.

Financial historians provide a longer-term overview of the course of interest rates. But even here there is little agreement. A much-cited 2019 paper by the academic Paul Schmelzing, now at Boston College, examined eight centuries of data and concluded that real interest rates had experienced a “suprasecular” decline over this time. The ultra-low interest rates of the last decade were not abnormal. Indeed, if the trend persisted Schmelzing forecast that “within a generation historically implied real interest rates will have reached negative territory”.

Schmelzing’s observation of the long-term downward trend is exaggerated by the high rates of the late medieval period before the establishment of modern financial capitalism. Furthermore, the negative real interest rates found at times during the past century are an artefact of unexpectedly high inflation — as we have experienced again over the past couple of years.

More importantly, Schmelzing’s linear extrapolation of an 800-year trendline into the near future ignores a key historical insight into bond markets. Namely, that long-term interest rates move in cycles, upwards and downwards, over lengthy periods. Sidney Homer and Richard Sylla carefully recorded many bond cycles in their classic “A History of Interest Rates”. After 1945, for instance, yields on U.S. Treasury bonds climbed an upward path for 35 years. From 1981, bond yields fell for four decades — roughly the same length as the bond bull market of the late nineteenth century.

The current bear market in bonds is two years old. If history is any guide, it has many years to run. Unfortunately, it does not provide much help as to the near-term direction of interest rates. That depends on how the current generation of central bankers respond to inflationary pressures and whether the financial system can withstand the impact of recent rate hikes.

Bond market history contains some other unsettling insights. Movements in interest rates are becoming more extreme. The 20th century witnessed the highest and lowest rates of the past five millennia. The 21st century has already broken the record on the downside. Homer and Sylla wryly observe that people assume that the interest rates they encounter are normal and are surprised by what comes next. That is what has happened over the past couple of years. Expect more interest rate shocks in future.

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Editing by Peter Thal Larsen, Streisand Neto and Thomas Shum

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