How to Explain the Divergence of Global Interest Rates
Global bond markets trade on variables such as currency valuations, global fund flows, inflation expectations and monetary policy that can determine the level of interest-rate differentials. Recently these differentials have widened dramatically, specifically in developed markets such as Japan, the U.K. and Germany, relative to the U.S.
There are multiple theories about why these differentials exist and how they may eventually narrow. Mainstream thinking holds that interest-rate differentials are caused when the Federal Reserve tightens policy as other central banks such as the Bank of Japan and the European Central Bank loosen. Yet here are however two underlying reasons for international interest-rate divergence.
The first reason was explained in a recent speech by the ECB board member Yves Mersch. He said there is a limit to how low (negative) rates can go, because at some point, they entice cash hoarding. The ECB must address this issue by communicating forward guidance, and markets have interpreted this as meaning that negative interest policy will likely end. On the other hand, negative yields exist because there is a need for “safe assets” that is caused by banks’ liquidity regulations, and by the ECB’s purchases of German government bonds that yield below the deposit rate.
These two reasons have caused a divergence between the two-year German government bond yield and expectations of the ECB policy rate two years ahead. On the one hand, markets expect the ECB to normalize negative rates in the next two years. Whereas German rates are driven by expectations of “safe-haven” for the next two years as the Brexit negotiations unfold and Germany has general elections. This divergence between policy-rate expectations and Germany yields may stay in place as Europe enters a politically uncertain year.
The second reason for rate divergence can be explained by real interest rates, or nominal interest rates adjusted for inflation. In a recent presentation, St. Louis Federal Reserve President James Bullard made the case that nominal interest rates are low because real interest rates have averaged -1.3 percent versus +0.75 percent pre-crisis. The explanation of a low real rate regime is that government bonds have an exceptional high-liquidity premium, productivity growth is low, and real rates of return on safe assets have been on a declining trend. Thus, a divergence opened between two-year U.S. nominal yield and real rates, expressed by yields from Treasury Inflation Protected Securities a few years forward. U.S. real rates are expected to stay low because of a gradual Fed tightening process, and because of uncertainty about how fiscal policy stimulus can change productivity and capital investment.
It is not unlikely that interest rate differentials may widen to new extremes before they reverse. This is because political uncertainty surrounding fiscal policy means uncertainty about how monetary policy may respond. Still, there is a limit or floor on how low or high interest rates can go before they become more permanently damaging to the financial system. Markets have taken a view that eventually the Fed will face a “ceiling” on U.S. short-term nominal interest rates, especially in the wake of excessive fiscal policy that may overheat the economy and cause a recession. In Europe, markets have expressed their opinion that negative rates can’t go on forever, and therefore the amount of negative yielding bonds has fallen from more than $10 trillion to less than $5 trillion, according to recent J.P. Morgan research estimates.
That leaves the “Catch 22”: how interest rate divergence is going to reverse. With inflation rising by commodity price and wage pressures, real interest rates may stay low. As markets are confident they have experienced a “bottom” on negative European rates, and markets are certain they see a “ceiling” for U.S. short term rates, interest rate divergence will eventually change when safe assets’ excessive liquidity premium erodes as investors recognize the after-tax real returns for government has declined further into negative territory. That time is coming relatively soon in a year in which developed market inflation is edging higher and central banks are beginning to move in tandem towards a more synchronized tightening cycle.
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