It is, by now, a familiar statistic, but one that retains its ability to shock: more than $13tn of government bonds are trading at negative yields. But while this may strike many as unnatural, it is not unprecedented. In the Great Inflation of the 1970s real interest rates were extremely low or negative across much of the developed world. A comparison between events in that earlier period with today’s seemingly freakish financial conditions contains several clues as to what may go wrong with monetary policy now.
The high inflation of the 1970s was essentially the result of the monetary dislocation that followed the breakdown of the Bretton Woods semi-fixed exchange rate system. Instead of a search for yield or a retreat into government paper, investors fled from supposedly safe assets such as fixed-interest IOUs into real assets such as property. The value of land, bricks and mortar ballooned in response to excessive money and credit expansion. A property-based financial crisis ensued, most notably in the UK, where the Bank of England had to organise a lifeboat operation to rescue fringe banks.
The losers, as is the case today, were the system’s creditors. But they lost a great deal more in the 1970s because as well as suffering from a lack of real income, soaring inflation severely eroded the value of their “safe” assets. Those investors who nonetheless stayed in fixed-income markets had their revenge. Under Paul Volcker the Federal Reserve in the 1980s tightened policy and bond markets offered unusually high real interest rates for a protracted period because it took so long for policy credibility to return.
One important difference today is that measures of the “natural” rate of interest consistent with normal economic conditions have been moving downwards for years. That helps explain another novelty, which is that some central banks have been running negative policy rates for sustained periods. The extreme case is the Swiss National Bank, which is a victim of the European Central Bank’s recent easing rhetoric. The SNB finds itself in the awkward position of having to choose between allowing the Swiss franc to appreciate to levels that tighten financial conditions while heavily penalising Swiss exporters, or cutting a policy rate that already stands at minus 0.75 per cent. The latter move could attract the ire of Donald Trump.
Since the great financial crisis, central bankers in advanced countries have also preferred to err on the side of easing. The Fed, for example, is widely expected to cut its policy rate next week, despite the economy chugging along tolerably well, inflation being close to target and unemployment near its lowest level for 50 years.
The doves on the Federal Open Market Committee claim to worry about a global slowdown because of the trade war. That is something that was not much of a concern in Mr Volcker’s day, when the US was a less open economy and China appeared to be of little economic importance. In its anti-inflationary zeal, by contrast, the Volcker Fed actually drained the world of liquidity and dramatically slowed the global economy.
Perhaps the most important difference between negative real rates in the 1970s and today relates to moral hazard. That is, current interest rates create an illusion of debt sustainability because it is so easy for governments, companies and households to service debt. Yet the debt has increased considerably since the financial crisis, reaching 245 per cent of world gross domestic product last year.
The difficulty for central banks is that, if inflation returns, it may prove impossible to damp down a rising price level without creating a financial crisis as debtors confront higher borrowing costs. Inertia may therefore triumph. Yet debt cannot accumulate forever. Such is the complacency on this score that the seeds of both financial instability and renewed inflation are probably being sown now.
That is not to say that the game is up for equity investors this year. If the Fed cuts the policy rate as expected it will be perceived as confirming the start of another round of monetary easing, more searching for yield and the possibility that stocks will reach further record highs. Supporting that hypothesis: survey evidence that fund managers are extremely underweight in equities, a point that tallies with a recent fall in US Treasury yields that was clearly driven by risk aversion.
Any uplift in equities may, of course, be interspersed with stomach-churning gyrations arising from the Trump trade war. But a benign short-term policy environment means that the music plays on for now.