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Special Focus: Low Yields Forever? Explaining The Interest Rates Conundrum

After rising to around 3 percent last year, the yield on 10 year U.S. Treasury bond has reversed course and recently moved as low as 2.30%. It seems like they continue to move lower toward the record low seen in 2012, when the 10 year Treasury bond yielded around 1.85%. Despite a small uptick in yields, it is rather surprising, especially considering the fact that the Federal Reserve is about to wind up its Quantitative Easing program, given the improvement in the economy and the falling unemployment rate, which currently stands at 6.1%. Interest rates are moving lower despite an improving economy? Something does not seem to be right here because normally rates should move higher as a reaction to a stronger economy and in light of a further normalization of the Fed's monetary policy. What is pushing yields down and what do the lower rates means for the outlook of the economy? We try to analyze this and give some answer to the new but old interest rates "conundrum".

In 1996, the former Federal Reserve chairman Alan Greenspan used the term "irrational exuberance" to describe what he believed was a stock market bubble. He simply couldn't explain the rather rapid increase in equity prices seen in the early 90's. Only very few people back at that time would have thought that equity markets were nowhere near their top, they continued to climb for another three years before their sharp correction early in the new millennium. Between 1998 and 2000, the Fed Funds rate rose from around 4 percent to 6.5 percent before the stock market started a large correction and the economy began to slow as all the hype and enthusiasm about the new age of technological revolution began to fade. In order to support the economy, the Federal Reserve began to lower interest rates and within less than 2 years (!!), the Fed Funds rate fell below 2 percent and eventually bottomed out at 1.5% in 2003/2004. The yield on 10 year Treasury bonds had fallen to around 4 percent which even surprised the Federal Reserve. Back in 2005, Alan Greenspan referred to the surprisingly low yields as a "conundrum", meaning that it was simply not possible to explain why yields had fallen so much. Today, almost 10 years after Greenspan first used the term conundrum, the Fed Funds rate is basically at zero and 10 year Treasury bond yields only 2.55%, which means they have fallen by another 40 percent compared with the levels seen in 2005.

There have been many reasons mentioned to explain why yields are so low but the fact is that long-term yields have been in decline for almost 25 years now, so it is obvious that some very powerful changes/factors are driving this. We will try to explain this in detail here.

We believe we are witnessing a rather unique combination of different factors that keep pushing yields lower. While some of those factors are structural in nature, others are directly related to monetary policies which have become increasingly expansionary in recent years. We should simply say here that global liquidity outright exploded in recent years. So we have a situation where there are inflationary factors and deflationary tendencies at work at the same time. This makes it hard to predict the future level of inflation and with it interest rates. At the very basic, the quantity theory of money is a good equation to look at the basic factors. The Quantity theory of money states that:

MV = PQ where M stands for money supply, V stands for the velocity of money, P stands for prices and Q stands for the quantity of goods and services produced. In theory, if the money creation and the velocity of the money supply grows faster than the economy, we should see higher prices eventually. So how can it be that the money supply has grown by almost 30 percent (annually) the past few years and prices have not gone up, or at least not much in most areas? The answer can be found in the velocity factor of money which measures how fast money is moving in the economy. The chart below (taken from the St. Louis Fed web page) clearly illustrates what is happening. Velocity has tumbled from the record highs reached in the mid 90's to new lows that we have not been seeing in more than 50 years, in fact we have never seen such low levels historically.


While part of this fall can be explained by the unprecedented increase in the money supply, the bottom line still is that money is not flowing as quickly as it should, meaning that the newly created liquidity does not find its way into the economy because business and private households are not investing and spending as much as the did in the past (long-term average). This also confirms that what matters is not so much the price of money (which is historically low) but more the willingness to invest and spend.

Monetary policy alone would be inflationary, even highly inflationary, but there are some very powerful trends at work here that are deflationary, in some cases even strongly deflationary. For example, since the end of the 90's labor force participation rates are falling, after reaching record highs some 15 years ago. This trend will continue as baby boomers are retiring and more and more people are unable to find or unwilling to seek employment. Fewer and fewer workers need to support a growing number of people that depend on the support of income earners. So even as official statistics show a declining jobless rate, labor participation continues to fall, therefore we should take official data with a grain of salt. With more and more people unable to find employment, the number of discouraged workers is at an all time high. Also a growing number of those who can find jobs are on time contracts or even only work part-time, often with lower pay than they had in their previous jobs. Also there seems to be more uncertainty regarding the future and what it might hold for the people. This is reflected in a very strong increase in the willingness to hoard money instead of spending/investing it. In general, there is a clear tendency for the private sector to think and act more short-term and hold more cash.

This combination of factors mentioned above can't be seen as a short-term phenomena but much rather like an indication what is going to be the new normal in coming years. The economies of developed nations are all driven by the same trends and factors and those are not going to be great in the next years, maybe not for the next one or two decades. This on the other hand does not mean that things will necessarily be bad, but economic growth and interest rates are going to stay well below their long-term averages (we do not expect any meaningful increase of interest rates in the next 12-24 months which will be positive for the stock market). Remember, in an economy with low growth and deflationary factors, the premium for productive capital, meaning share prices for highly successful/profitable companies should increase not decrease. We therefore expect a further, maybe significant increase in global equity prices. These higher prices will not be primarily driven by profit growth but an increasing valuation of these profits which would imply a further increase in P/E levels in the years to come.