Why Are Interest Rates So Low

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Why Are Interest Rates So Low?
Joachim Fels Chief Global Fixed Income
EconomistTel 44-20-7425-6138Joachim.Fels_at_morgan
stanley.com
April 2005
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A 300-Year ViewNominal Interest Rates Are Not
Exceptionally Low
UK Nominal Long-Term Interest Rate (2.5 Consol)
Sources Datastream, Global Financial Data, DMO,
D.Miles, M. Baker, V. Pillonca, Where Should
Long-Term Interest Rates Be Today? A 300 Year
View, Morgan Stanley, 9 March 2005
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A 300-Year ViewBut Real Interest Rates Are Very
Low
UK Real Long-Term Interest Rate
Sources Datastream, Global Financial Data, DMO,
D.Miles, M. Baker, V. Pillonca, Where Should
Long-Term Interest Rates Be Today? A 300 Year
View, Morgan Stanley, 9 March 2005
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Real Yields on US and French Inflation-Proof Bonds
This is not a continuous series it links
together bonds to approximate a 10-year series.
Discontinuities are marked.Source Bloomberg,
French Treasury, Morgan Stanley Research
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Greenspans Conundrum
Resulting in a Flattening of the US Yield Curve
Long-Term Yields Fell During 2004 Despite Fed
Tightening
Source Datastream, Morgan Stanley Research
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Five Implausible Explanation for Low Yields

• Growth pessimism has depressed real yields But
  why then are equities up and risk spreads low?
• Deflation fears have depressed nominal
  yieldsBut survey- and market-based inflation
  expectations have risen
• Lower risk premium due to higher central bank
  credibility But whence a sudden surge in
  credibility?
• Rising risk aversionBut risky assets have even
  outperformed bonds until March
• Asia central banks appetite for TreasuriesBut
  Euro bonds have rallied even more

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Global Credit Spreads Tight, Tighter, the
Tightest
bp
Source Morgan Stanley Research, MSCI, Yield
Book Note Chart shows premium for owning BBBs
over AAs.
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However, Risk Spreads Have Widened Recently
As Are Emerging Market Spreads
US and European Credit Spreads on the Rise
Source Datastream, Morgan Stanley Research
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US Inflation Expectations on the Rise
Breakeven Inflation Rates US versus Euro Area

• The correlation between US and euro area
  inflation expectations appears to have broken
  down recently
• Markets are pricing in higer inflation in the US,
  lower in the euro area
• Good reasons for further divergence EUR/USD
  strength productivity growth convergence
• More European bond outperformance ahead

Source Bloomberg, Morgan Stanley Research
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The Real Culprit Excess Liquidity
Indicators of Global Excess Liquidity

• Record-low interest rates have pumped up money
  supply and credit
• The outstanding stock money and credit relative
  to nominal GDP is at a record high
• ECB to take over from Fed as marginal provider of
  excess liquidity
• Excess liquidity is pushing up the prices of
  real and financial assets
• This raises the two-way risk to future inflation
  inflation or deflation could result

Source IMF, OECD, Morgan Stanley Research
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Reflecting Ueber-Expansionary Monetary Policies
The Big Monetary Easing Real Short Rates in
Negative Territory

• Recession, post-bubble woes and deflation fears
  led the big central banks to open the floodgates
• The consequences of negative real interest rates
  
• excess liquidity, over-investment, asset
  bubbles
• and a sharp cyclical rebound fuelling an
  endogenous oil price shock

Source Datastream, Morgan Stanley Research
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How Much of a Housing Bubble in Spain?
Spanish House Prices Actual, Predicted and Gap

• Valuation model linking long-run trend in house
  prices to household disposable income and the
  equity market return
• As in UK, interest rates help explain short-run
  dynamics, but not long-run trend of house prices
• As in UK, model suggests Spanish house prices
  some 30 above fair value
• High vulnerability when ECB raises rates and/or
  economy falters

Source Bank of Spain, Morgan Stanley Research
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Five Scary Parallels with the 1970s

• Oil shock the price of oil quintupled from
  1971-74 and from 1999-2004
• Competitive shock new competitors in world
  markets cause dislocation. Now China India,
  then Japan and Korea
• Productivity slowdown just as the 1960s
  productivity boom gave way to the 1970s slowdown,
  we are now at the tail-end of the recent
  productivity boom
• Expansionary monetary policy as in the 1970s,
  central banks appear to be willing to accommodate
  negative supply shocks
• Fiscal slippage rising budget deficits
  reflecting economic weakness and (in the US) the
  financing of an expensive war (then Vietnam, now
  Iraq)

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US Productivity Growth The Best is Behind Us
US Productivity Growth Moves in Long Cycles

• We are likely at the tail-end of the IT-enabled
  productivity acceleration that started in the
  mid-1990s
• The easy productivity gains have been made,
  especially in the US, and productivity growth
  should normalise in the coming years
• If the Fed overestimates trend growth, as it did
  in the 1970s, its policy will be inflationary

Source Bureau of Labor Statistics, Morgan
Stanley Research
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The Case for Higher Global Inflation

• Central banks want it as a safety margin against
  deflation
• Indebted consumers, companies and governments
  want it to alleviate the real burden of debt
• Structurally high demand for oil and other raw
  materials provides cost push
• Expansionary monetary and fiscal policies provide
  demand pull
• The productivity boom in the US is behind us

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Towards Higher Fiscal Deficits

• The Euros fiscal framework is in shambles The
  new Stability and Growth Pact lacks teeth. The
  political sanction mechanism for fiscal sinners
  has been virtually abolished.
• Markets dont sanction fiscal profligacy either
  Yield spreads between government bonds in the
  euro area are extremely tight
• Why markets are unable and unwilling to impose
  discipline (1) Most countries are fiscal sinners
  now (2) excess liquidity compresses yield
  spreads (3) markets believe the non-bailout
  clause in the Maastricht treaty is not credible
  (4) the ECB treats all governments as equal at
  its refi operations
• Without sanctions, look for higher deficits
  Political tensions between member states will
  rise and more pressure on the ECB to engineer
  higher inflation will result. The worst case
  scenario is EMU break-up

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Disclaimers
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Disclaimers