A spectre is haunting Europe — the spectre of negative rates. The bad news for investors is that Europe is going to have to get used to them.
Today Germany sold five-year bonds at a negative yield (meaning that investors were paying the German government to borrow) for the first time in history. And they are not alone. Across Europe the five-year government debt of Finland, the Netherlands and Austria is also trading at negative yields, according to the Financial Times.
If that seems unusual, it should. It is indicative primarily of the mess that Europe has got itself into with investors desperate to pile their money into “safe assets” where they can limit their losses in case of an economic setback.
Another motivating factor is that the average yield on the Germany five-year bonds was -0.08%, which is still a premium to the European Central Bank’s interest rate that it pays on deposits held at the central bank (-0.2%).
Much of the current discussion on the theme of negative rates revolves around short-term factors, such as the ongoing negotiations over extending the Greek bailout programme and the threat of deflation in the Eurozone. These undoubtedly have had an impact on sentiment and helped to drive borrowing costs for governments down over the past few years.
Yet the trend of falling interest rates significantly pre-dates the current crisis, and indeed the global financial crises that preceded it. The chart below from the Federal Reserve’s economic database (FRED) shows the 10 year borrowing costs of Germany, France, Italy and Spain from 1990 to 2014.
Part of this reflects the success of central banks in taming inflation after introducing inflation targets. As the IMF’s 2005 World Economic Outlook stated, “inflation targeting appears to have been associated with lower inflation, lower inflation expectations and lower inflation volatility relative to countries that have not adopted it”.
Lower inflation expectations mean that investors demand less of an interest rate premium to protect them from the possible impact of prices rising faster than their returns. This meant that governments could offer lower interest rates on their debt and still remain an attractive prospect for investors.
However, falling rates can also indicate something more worrying — lower growth expectations. If investors believe that economic growth will be lower in future then they are more willing to accept lower interest rates on government debt as the returns on investment generally are likely to be lower and inflation even more restrained.
That is, low rates can also be a signal of bad times ahead.
Why should growth be lower in future? One possible answer is the impact of ageing in the West.
There is no doubt that developed economies are seeing demographic decline, with the average age of the populations creeping ever upwards. In Europe and Japan, this trend is perhaps most advanced.
Below are the European Commission’s projections for population development in Europe between 2010 and 2030. Each of the rectangular blocks represent an age cohort and, as you can see, even over the next 20 years the share of 60+ cohorts increases substantially.
Another point of note is that, as societies age the share of the population that remains in the workforce also falls. That means that there will be fewer workers to support a rising number of pensioners.
It also suggests that, absent very large gains in worker productivity (the ability of workers to produce more goods and services for the same cost), it is going to have a substantial impact on economic growth.
Some of the projection for just how big this hit to GDP could be are downright frightening. For example, a 1999 paper by
economists in the Directorate-General for Economic and Financial
Affairs (ECFIN) of the European Commission estimated that “ageing is expected to reduce the annual average rate of growth, relative to the baseline, by close to ½ a percentage point in the case of the EU and Japan and around a ¼ of a percentage point in the US”.
That would mean that the base line rate of growth in Europe would fall from around 2.25% per year to 1.75% between 2000 and 2050. And this is what that would mean — the level of GDP over that period would be 18% lower relative to what it would have been if growth had continued at its trend rate of over 2%.
This has potential implications for how much debt a government can service in future, limiting its ability to borrow today. It also suggests that living standards might be squeezed permanently in a way that Western societies have not had to face for generations.
To some extent ageing societies offer their own solutions to the problems that they create. Older societies tend to save a greater share of their income much of which goes into “safe” government bonds, which helps lower long-term interest rates.
This means that although the government might have to spend more supporting an older population, that population is more willing to contribute to that effort than they are at present. Moreover, due to people’s increased propensity to save rather than spend central banks are likely to have to undertake more unorthodox policy in order to keep inflation near to target.
This could include large scale purchases of government bonds, providing an even lower interest rate environment and greater flexibility for governments to support their people. (If this sounds like monetisation of debt, whereby two different arms of the state effectively exchange debt for freshly printed cash, it should. But if you think it means hyperinflation or a fiscal crisis, I refer you to Japan’s experience)
This could mean that, in future, people will be happy holding bonds at negative rates (at least, negative real rates if not negative nominal rates). We might not be there just yet — Europe’s current round of negative rates owes much more to massive policy failure than it does the slow grind of demographics — but the longer term trend is becoming harder and harder to ignore.
Whether you call it secular stagnation or not, the reality is negative rates might be something we have to get used to.