Sunday , September 15 2019

Low bond yields

Summary:
Why are interest rates so low?Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward trend since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the extra ...

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Why are interest rates so low?

Low bond yields

Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward trend since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the extra volatility that past inflation induces. But you can also see that real yields have fallen with the same pattern.

There is lots of discussion. A falling marginal product of capital, due to falling innovation, less need for new capital, a "savings glut," and so forth are common ideas. The use of government bonds in finance, the money-like nature of government debt among other institutional investors and liquidity stories are strong too. And most of the press is consumed with QE and central bank purchases holding down long term rates. I hope the steadiness of the trend cures that promptly.

Along the way in another project, though, I made the following graph:

Low bond yields
The blue line is 10 times the growth rate of nondurable + services per capita (quarterly data, growth from a year ago). The red line is the negative of an approximate measure of the real return on 10 year government bonds. I took 10 x (yield - yield a year ago), and subtracted off the CPI.

Look at the last recession. Consumption fell like a rock, while the real return on long-term bonds was great. That real return came from a double whammy: long term bonds had great nominal returns as interest rates fell, and there was a big decline in inflation.  No shock, there is a "flight to quality" in recessions, along with a sharp decline in nominal rates. From a foreign perspective, the rise in the dollar added to the return of long-term bonds. The graph suggests this is a regular pattern going back to the almost-recession of 1987. In every recession, consumption falls, interest rates fall, inflation falls, so the real ex post return on government bonds rises.

Government bonds are negative beta securities. At least measured by consumption or recession betas.  Negative beta securities should have low expected returns. They should be less even than real risk free rates. I haven't seen that simple thought anywhere in the discussion of low long-term interest rates.  

Making the graph, I noticed it was not always thus. 1975, 1980, and 1982 have precisely the opposite sign. These were stagflations, times when bad economic times coincided with higher inflation and higher interest rates. Likewise, countries such as Argentina which go through periodic currency crises, devaluations, and inflations, flights to the dollar, all associated with bad economic times, should have the opposite sign. There is a hint that 1970 was of the current variety.

One could easily make a story for the sign flip, involving recessions caused by monetary policy and attempts to control inflation, vs. recessions involving financial problems in which people run to, rather than from, money in the recession.

In any case, the period of high yields was associated with government bonds that do worse in recessions, and the period of low yields is associated with government bonds that do better in recessions and have a negative beta. I haven't really seen that point made, though I am not fully up on the literature on time-varying betas in bond markets.

In any case, if we want to understand risk premiums in bond markets, this sort of simple macro story might be a good starting point before layering on institutional complexities.
John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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