Since November 2016 we have taken the view, that long term interest rates are set to rise. We believed the Trump administration would enact expansionary fiscal policies. With the economy near full employment and wage pressures rising, the stage is set for inflationary expectation to rise. At the same time the Fed’s policy is on a tightening cycle. Taken together all these factors suggested that long term interest rates were bound to rise. Yet, not only has this not happened, but long term rates declined this year.
Long term bonds are sending a signal…
Declining long term rates can be sending many signals, including increased uncertainty, declining growth prospects, and falling inflationary expectations. If the main reason for declining bond yields is related to increasing uncertainty, how can we explain buoyant equity markets? Equity and fixed income investors are not operating on different planets. Similarly, high yield and emerging market bonds are also signalling a relatively benign outlook. The answer to this question must lie elsewhere.
The equilibrium level of long term interest rates is related to the long-term level of nominal growth of GDP, which is real growth plus inflation. Intuitively, the relation is as follows: if long term rates drop below the level of GDP growth, then it becomes profitable to borrow and invest today. The increased demand for long term borrowing raises interest rates. The reverse is also true. Why has all the increase in long term borrowing by governments and corporations happened while 10 year US Treasury yields are back to a puny 2.5%?
…that the growth outlook remains subdued
Analysts often brandish explanations such as supply and demand dynamics for high quality bonds, as well as the quantitative easing measures of central banks. These factors certainly have an impact over limited periods of time. However, short term flows cannot forever defy the gravity of long term fundamentals. We believe that the more plausible reason is that the long-term growth outlook remains very subdued.
At a very basic level, GDP growth is determined by three factors: growth in labour, growth in capital, and growth in productivity. The first two factors are somewhat simple to measure. Measures of changes in productivity, however, are effectively a measure of the part of GDP growth that cannot be explained by either change in labour or capital.
What do underlying trends in these three factors portend for the growth outlook? Demographic trends suggest that labour force growth will remain muted. The high participation rate (about 85%) of the most productive segment of the population (25-55) indicates that there is limited scope of potential tailwinds from increasing labour force participation. This implies that achieving a higher growth trajectory will need to be a function of either increased investment and/or productivity.
Increasing growth requires higher level of investment
While investment has been growing, productivity growth has been on a declining trend. After peaking around 3% around 2005, productivity grew by an average of 0.5% since 2012. The reasons for the decline are not immediately obvious. The past two decades have seen the introduction of new technology into virtually every aspect of our daily lives. Has none of it improved our productivity?
There are two schools of thought on this issue. The pessimistic view, championed by economists like Robert Gordon, is that the impact of recent technological innovations is simply not as productivity-enhancing as previous innovations. For example, the internet did not enhance our means of production in the same way as the invention of electricity. A similar argument was also put forward by Tyler Cowen, which states that advanced economies have become complacent. This is manifest by the fact that the convenience afforded by technological innovations have been used by consumers primarily to increase and enhance leisure rather than productivity.
The more optimistic view, championed by economists like John Taylor, is that productivity growth has been slow because investment growth has also been slow. New technologies are being developed but their introduction in the manufacturing and services sectors has lagged their full potential. This, in turn, is due to the high regulatory burden as well as high marginal tax rates on capital and business enterprises. Witnessing the high share of corporate profits allocated to share buy-backs and dividends supports this view.
Long term rates are unlikely to rise soon
The two views above are not mutually exclusive. Both would suggest that unless and until there is a meaningful change to the growth outlook, it is unlikely that long term rates will rise significantly. This in turn cannot merely happen by tax cuts, but by a meaningful package of tax and regulatory reform. But recent experience with healthcare reform suggests that the chances of compromise in Congress that would lead to coherent reform is not especially high.
