Have We Entered the Twilight Zone?

On January 25, 2006, Phillip Bowring wrote this op-ed piece in the NYT on pension liabilities:

A remarkable if obscure event last week highlighted the potentially colossal impact on the global economy of the collision of two forces: the pension needs of aging populations throughout the developed world and the collapse of long-term interest rates. Pensions do not feature in the long list of subjects to be discussed at the World Economic Forum in Davos this week, but they ought to.

The event last week was the fall in the rate of return of 50-year inflation-indexed British government bonds to under 0.4 percent. That is far worse than anything even Japanese savers have experienced - the inflation adjusted on yen bonds was never below 1 percent.

The British bond bubble is exceptional and caused in part by regulations that force pension fund trustees to seek safety more than yield. But it is also part of a global phenomenon. For example, yields on 20-year U.S. Treasury inflation-protected bonds are 1.9 percent and those on French, Canadian and other equivalents are lower. Conventional bond yields are close to record lows almost everywhere, including emerging and higher risk markets such as Russia and Argentina.

So why should this be a problem? Are not low interest rates good for economies, stimulating consumption and encouraging investment? Unfortunately, not always - particularly when pension schemes in many companies and countries are already inadequate to meet future obligations.

In the case of Britain, the fall in long-term rates over the past year has added $30 billion to the existing pension fund deficits. In the United States, many funds already had overly optimistic of rates of return on funds. For the time being, a pick-up in some equity markets may be delaying a day of reckoning. But funds assuming an annual return of 8 percent to 9 percent, when 10-year treasuries yield half that and corporate dividend yields are under 2 percent, will face a crisis if yields do not rise.

Low long-term interest rates are having or will have very serious negative consequences that outweigh temporary apparent benefits:

The more aware corporations become of the further growth in their unfunded pension liabilities, the less willing will they be to invest surplus cash in new ventures. It will go to shore up the funds. In the United States, the weak corporate investment response to very healthy profits suggests this is happening already.

As in Japan, low interest rates have minimal impact on willingness to consume. Instead they make it seemingly painless for the government to borrow heavily for investment in schemes and bridges to nowhere.

Low long-term interest rates encourage asset bubbles of all sorts. The world may not be in an equity bubble but many parts of it have been enjoying property bubbles - and now the bond bubble. That gives central banks, fearful of bubbles bursting, reason to delay return to more normal rates.

Low rates of return from bond and equity markets encourage a shift into nonconventional assets such as hedge funds and private equity. These promise higher returns but their lack of transparency and high leverage promise more train wrecks ahead.

Annuity yields are so low that pensioners will be forced to rely on the state for welfare.

It has become fashionable in the West to see "excess Asian savings" as the main cause of low bond yields. Yes, there is scope for China, South Korea, Japan and parts of Southeast Asia to spend more and save less. There is a trend in that direction already - and, in time, oil exporters now accumulating vast surpluses will also spend more of their new wealth.

None of this can adequately explain, however, why real interest rates in the United States can be at record lows while household saving is nonexistent and the government deficit enormous.Or why British rates are so low despite record levels of household debt and a rising government deficit.

A more plausible explanation is the extraordinarily rapid pace of money supply growth almost everywhere - in Europe, Australia and even Japan as well as in the lead money printer, the United States. Rapid expansion of reserve currencies has quickly been followed by monetary surges in Asia and Latin America.

Of course there are other influences. In the information technology era, growth may be less capital-intensive than during the era of steel. And global demographic change is adding to savings and reducing growth in demand for new houses and factories.

But the major central bankers and finance ministers should stop either blaming the Asiansor just musing over the causes of low rates. Individually and severally, they are supposed to be in control of money creation, credit growth and the supply of long-term public debt.

The problems of aging and pensions were already challenging enough. Current attempts to buy short-term expansion with artificially low interest rates can only make the long-term problems greater than ever.

Keep in mind that was written back in 2006, before the financial crisis hit. What has happened since then? Unfortunately, not much has changed:

• There are fewer hedge funds but they control more assets. The same goes for the big banks where assets are concentrated in the hands of a few.
• On Tuesday, Dominique Strauss-Kahn, the managing director of the IMF said international drive to impose new regulations in the wake of the financial crisis is fading and global cooperation is diminishing.
• Wall Street's bonus bonanza continues. The FT reports that top 400 executives of Credit Suisse will share a jackpot of more than SFr3bn when a special bonus scheme that reached maturity on Wednesday pays out next month.
• Judging from the meeting organized by the Institutional Limited Partners Association on Tuesday, in New York, the LPs want to elevate the dialogue with GPs -- to the industry level. But it is just a dialogue. Partly because there is less capital to go around for new funds against the backdrop of a vastly different environment, the give and take between GPs and LPs has become much more complex. Nonetheless, in the current tug of war, very few GPs have shown willingness to compromise on terms - of the 100 or so organizations that have endorsed the ILPA principles, only a few private equity firms have signed on.
• Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said the Fed is right to pledge to keep rates at record lows for an "extended period." But he — as Federal Reserve Chairman Ben Bernanke did last week — said that doesn't mean a specific time period or number of meetings.
• Investors should acclimate themselves to years of lower-than-normal returns in both stocks and bonds, Pimco's Bill Gross told CNBC.

On the last two points, the Economist had an interesting discussion on the Dangerous curve:

What is going on in government-bond markets? Longer-dated bond yields have risen in recent weeks and the gap between long- and short-term rates (known as the “yield curve”) is much higher than normal. Potential explanations range from the benign (the economy is returning to normal) to the apocalyptic (investors have lost their appetite for government debt).

An upward-sloping yield curve, in which long-term interest rates are above short-term rates, is normal. You would expect creditors to demand a higher return for tying up their money for extended periods. An “inverted” curve, with short rates above long ones, is usually seen as a herald of recession, as it turned out to be before the credit crunch.

So what does a very steep yield curve tell us? One possibility is that the economy is heading for a vigorous recovery. For one thing, long rates are a forecast of future short rates. So the markets are essentially predicting that the Federal Reserve will eventually increase rates because the economy has been restored to health. In addition a steep yield curve creates profitable opportunities for banks, which can borrow short-term at a low rate and lend to companies at a higher one. The Fed engineered a steep yield curve in the early 1990s to boost bank profits after the savings-and-loan crisis.

This time, however, a steep yield curve is hardly stimulating bank lending. Bank credit has contracted over the past 12 months. Big companies are turning away from the banks to the bond market as a result: high-yield bond issuance in March broke the previous monthly record. Smaller companies have found it more difficult to borrow money.

A rise in long-term bond yields could indicate a belief that inflation is set to soar. But inflation expectations, derived from the gap between yields on index-linked and conventional bonds, hardly suggest fears of a Zimbabwe-style debasement. American inflation is expected to average just 2.4% between now and 2028.

There are other possibilities. One current technical oddity in the markets is the “negative swap spread”. In the interest-rate swap market borrowers exchange fixed-rate streams of payments for floating ones (or vice versa). The floating rate is often based on LIBOR, the rate at which banks borrow from one another. The fixed-rate element normally carries a higher yield than that of Treasury bonds with the same maturity. After all, the other counterparty in the swap will usually be a bank, which is less creditworthy than the American government. But on March 30th the fixed-rate element of a ten-year swap was paying 3.82%, while the equivalent Treasury bond was yielding 3.87%. Does that really mean the market considers banks a better credit risk than the Treasury? Given the continued use by banks of government-support schemes of various kinds, that seems ridiculous.

A more likely explanation is the sheer volume of bonds being issued. These bond issuers would rather swap their fixed-rate obligations for floating-rate ones. So they have to pay a floating rate and receive a fixed one. The result is an imbalance of supply and demand: those people willing to pay the fixed-rate part of the swap can get away with a lower yield than the American government.

In Britain a similar technical oddity has led to the 30-year swap spread being negative for a considerable period already. Demand from British pension funds, which use the swap market to hedge their long-term liabilities, has forced down fixed-swap rates. What is seen as an unusual situation in the American market may become the norm.

Technicalities aside, the most plausible explanation for the steep yield curve is the interaction of monetary and fiscal policy. On the monetary side the Fed is holding short rates at historically low levels in response to the severity of the crisis. On the fiscal side America’s budget deficit has soared to over 10% of GDP, leading to heavy debt issuance. Recent Treasury-bond auctions have seen fairly weak demand, forcing yields higher.

This still represents a challenge for markets. One reason why equities have rallied is that their potential returns have seemed attractive relative to government-bond yields. Now there will be more competition. And governments have been able to support their economies so generously because their financing costs have been so low. Higher yields will add to the pressure on them to tighten fiscal policy. A market and an economy too dependent on government support will have to learn to live without its crutch.

The problems of aging and pensions are only going to exacerbate fiscal woes, placing more upward pressure on bond yields as heavy debt issuance will continue to cover these costs.

Finally, there is a real risk that tightening fiscal policy at a time when private demand remains weak could send economies back into recession. Welcome to the twilight zone.