Rabu, 25 Juli 2012

The global yield plunge

As this chart shows, refinancing activity has been very strong and on the rise since early last year. I should know, as we are just finishing our second refi in the past 12 months. With a new 30-yr mortgage, our monthly payments will now be almost 30% less than they were a year ago. That frees up cash for all sorts of things, and if rates ever go back up, I'll feel like I've won the lottery. And if they should continue to fall, well then, I'll just refinance again. I keep thinking that someday I'll look back and congratulate myself for locking in a historically cheap rate (and tax deductible too!) on 30-yr money. There might never be another opportunity to borrow money at a fixed, after-tax cost of only 2-3%.

The other side to this coin is that the person lending me the money has seen a big reduction in his interest income. Actually, there is a massive amount of money all over the world that is being forced into lending at lower and lower interest rates. Most mortgages can be refinanced relatively easily when rates fall, but when rates rise, mortgages turn into long-maturity bonds because homeowners have a disincentive to move or refinance. Lenders thus see their MBS holdings behave like short-term deposits when rates fall, and like long-term bonds when rates rise—it's a painful experience.

And it's not just in the U.S. that yields have collapsed. As the first chart above shows, 10-yr sovereign yields in the U.S. and Germany are rapidly approaching the super-low level of Japanese yields. Who would have believed this could happen? I've been dead wrong on my prediction several years ago that Treasury yields would be much higher than they are today. And it's not because inflation has dropped or that deflation threatens; inflation expectations embedded in TIPS and Treasury prices are firmly in the range of 2 - 2.5%, which is very much in line with what inflation has been over the past 10-15 years.

The yield on 10-yr Treasuries, which is the principle driver of fixed mortgage rates, is down not because the Fed has engaged in quantitative easing or "operation twist," but because yields everywhere are falling.

The world's major central banks are the proximate driving force behind the global yield plunge. As the chart above shows, they have pegged short-term rates to near-zero for over three years, and no one even hints at raising rates anytime soon. Why? Because markets and central bankers all believe that global growth is going to be very disappointing, and easy money is believed to be the only policy lever that might work to stimulate growth. Fiscal "stimulus" spending has been tried and it has failed. But never mind: as Treasury Secretary Geithner made clear in a speech today, "The economy is not growing fast enough. Unemployment is very high. There's a huge amount of damage left in the housing market. Americans are living with the scars of this crisis. The institutions with authority should be doing everything they can to try to make economic growth stronger ..."

Central banks can influence bond yields by the manner in which they target short-term interest rates and future expectations of short-term interest rates: if they say, as they have done for years now, that short-term rates will be kept low indefinitely in order to combat pervasive economic weakness, then yields all across the maturity spectrum will experience a strong gravitational pull downwards. The only thing that can push rates up is faster growth and/or a reversal of demands for policy stimulus.

What the history of low rates and disappointingly slow growth should tell us, however, is that easy money (e.g., very low short-term interest rates) doesn't stimulate growth. How are low interest rates going to create jobs, when fiscal deficits are gobbling up a gigantic amount of the global economy's resources? (One easy illustration of this is the billions of dollars that the U.S. government has poured into "green" industries that have yet to produce anything profitably.) In the U.S., our federal deficit has effectively absorbed every dime of total after-tax corporate profits for the last several years. Keeping interest rates low only facilitates government borrowing, while at the same time transferring wealth from savers to borrowers.

It's become a vicious circle of sorts: government spends more than it takes in and borrows the difference; excessive spending weakens the economy because much of it takes the form of transfer payments and inefficient spending; the weak economy prompts central banks to keep rates low; and lower rates facilitate more wasteful borrowing. Meanwhile, savers accept the lower rates because they have no confidence that things will improve; witness the huge, $2.3 trillion increase in savings deposits in the U.S. in the past four years that pay almost nothing.

Lower interest rates aren't going to stimulate the economy. They are better thought of as barometers for how weak the economy is perceived to be. This is not going to change in any meaningful way until policymakers—with the prodding of markets—realize that the way to get out of this vicious circle is to cut back on the size and scope of government. The sound and fury coming out of the Eurozone these days is all about this: governments and their constituencies fighting the efforts of markets to impose healthy fiscal discipline. The only countries where yields are rising are the ones (e.g., Spain) where markets see that spending and borrowing are on a collision course that can only end in tears. Fortunately, the bond market vigilantes have driven Spanish yields up to levels that will make it very difficult for the government to avoid the inevitable cuts in spending. This is how it should be.

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