Jeremy Warner's Outlook: The conundrum of low long-term rates is easily answered. They are just too damn low

Bring back the lira; all is forgiven
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The Independent Online

Alan Greenspan, chairman of the US Federal Reserve, has called it a "conundrum". The Bank of England prefers the word "puzzle". However you want to describe it, no one has yet come up with a wholly convincing explanation for why long-term interest rates should be so low. Indeed, most commentators believe them to be dangerously so, exposing bond investors to the risk of very substantial loss when yields correct to more normal levels.

Alan Greenspan, chairman of the US Federal Reserve, has called it a "conundrum". The Bank of England prefers the word "puzzle". However you want to describe it, no one has yet come up with a wholly convincing explanation for why long-term interest rates should be so low. Indeed, most commentators believe them to be dangerously so, exposing bond investors to the risk of very substantial loss when yields correct to more normal levels.

Rising US inflation and short-term interest rates should cause long Treasury yields to rise in tandem. So far they haven't. To the contrary, the yield curve - which is the difference between short and long-term rates - has instead grown steadily flatter. As short-term rates have risen, long-term rates have fallen. The yield on 10-year Treasury bonds again dipped below 4 per cent this week, taking it close to its lowest level in more than three decades. Mr Greenspan's conundrum is even more of a puzzle than when he first highlighted the issue. Predictions that long bond yields would eventually self correct have been confounded.

One commentator who thinks rates may be going lower still is Stephen King, chief economist at HSBC and also The Independent's Monday economics columnist. In research published this week, "From Bondage to the Promised Land", he predicts that US Treasury yields have further to fall, to perhaps as little as 3.5 per cent during the course of 2006. What's more, he expects them to remain exceptionally low into the indefinite future, even though there might be a few frights along the way.

Why should he think this? Mr King postulates a number of reasons. One is convergence of capital markets, with persistent economic weakness in Germany and Japan causing bond yields to be lower the world over. To a Japanese investor, US Treasury bonds at 4 per cent may look good value against Japanese government bonds at little more than 1 per cent.

Another reason is that bond holders don't expect their investment to be destroyed by inflation any longer. This may be naive, but there are good reasons for thinking inflation is dead, not least the apparent determination of central bankers to keep it under control. If you are certain central bankers will do all that is necessary, even at the risk of destroying growth, to meet their inflation targets, then again it may be reasonable for long rates to be permanently lower.

A third reason lies in demographics. Ageing populations are bringing about a possibly permanent shift in savings, greatly encouraged by risk averse regulators, away from high risk, capital growth assets such as equities and into income yielding assets, particularly government bonds. This trend is probably being compounded by the end of the 1990s investment boom. Where once corporate cash flows would have been reinvested in business expansion, they now tend to go towards buy-backs, dividends and other forms of capital distribution. That money will ultimately find its way into bond markets.

Then there is Asian central bank currency intervention. In an effort to support burgeoning trade surpluses with America, Asian central banks have engaged in massive sales of their own currencies. The foreign reserves they have acquired are primarily held in US Treasury bonds.

To these reasons it is worth adding some others that were referred to in the Bank of England's last Inflation Report. Economic theory suggests that real long-term interest rates are determined by the need to bring desired savings and planned investment into line. Higher desired savings should push interest rates down, as should lower planned investment, as both cause economic activity to slow. There's not much sign of increased saving in Britain and America right now, but across the world as a whole it has been rising sharply as a proportion of GDP for most of the last decade. This largely reflects increased saving in emerging Asian economies. Asian households have been saving much more than they need to fund domestic investment needs.

That money has instead been used to buy foreign assets, in particular US Treasury bonds, through Asian central bank currency intervention. It's a funny old world that has the aspiring, generally quite poor economies of Asia helping to fund consumption in the world's richest economy, but that's capitalism for you. Markets may also be anticipating that eventually even US citizens will have to stop consuming and start saving. At the same time, lower rates also anticipate lower levels of investment, with companies facing almost impossibly demanding pressure to demonstrate they are investing their capital wisely. Just give it back to us is the growing refrain of investors.

Higher savings in combination with lower investment means lower growth, less inflation and more money pouring into government debt. Perhaps equally important is the "search for yield". With short-term rates so low for so long, particularly in the US - until quite recently US rates wouldn't even cover the rate of inflation - investors are driven further up the yield curve in the search for better rates of return. Short-term money is forced into longer dated securities.

So if a combination of all these reasons is the explanation for low long-term interest rates, where's the conundrum? Well, perhaps Mr King has answered it, but somehow I doubt that. Nor do any of these reasons seem to me to offer the assurance of permanently low long-term interest rates. Indeed, there is a high chance that one or more of them could reverse, causing real bond rates to rise quite sharply.

By historic standards, they are just way too low. Would you buy 10 year Treasury bonds on a real (inflation adjusted) yield of less than 2 per cent? You'd be a brave man to think inflation won't at some stage in the next 10 years wipe out even that pathetically small rate of return. Personally I'm going to leave my pension "safely" tucked away in "high risk" UK equities.

The bond market is a bubble if ever I saw one, and however compelling the arguments, I refuse to get sucked in. Yields need to be at least a percentage point higher properly to reflect the risk that what in essence is just a series of anomalies holding the whole low yield edifice aloft will suddenly come tumbling down.

Bring back the lira; all is forgiven

The unmasking of Deep Throat this week as Mark Felt, former deputy director of the FBI, puts me in mind of a particularly memorable line from the Watergate tapes. At the height of the storm, an official marches into the Oval Office to announce: "Mr President, Sir. We have a lira crisis on our hands." Mr Nixon, who's mind was on rather weightier matters, including his future, replied in suitably brisk terms: "F*** the Italian lira."

Most Italians wanted to do the same, and when the opportunity to join the euro came along, they grabbed it with both hands. Based as it was around the strong German mark, the single currency promised low inflation, low interest rates and economic stability, against a history of currency and financial crisis. Memories are plainly short. A member of the Italian government, Roberto Maroni, yesterday stunned colleagues and markets alike by suggesting Italy should quit the euro and reintroduce the lira.

Mr Maroni is hardly typical. He's a member of the Northern League, which is separatist and eurosceptic. Yet Mr Maroni makes a key mistake in thinking Italy could replicate British economic success merely by reintroducing its own currency. The immediate effect of leaving the euro would be to plunge the country into an even bigger economic mess than it is in already. Italy would get its desired devaluation, theoretically making its industry more competitive, but it would also get rampant inflation and sky high interest rates. Best, perhaps, to stick with the euro.

j.warner@independent.co.uk

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