A lot of attention has been paid recently to negative interest rates in Europe and Japan, prompted by aggressive central bank policy designed to stimulate economic growth. As a result, savers and bond investors in Europe and Japan are, in some cases, having to pay interest rather than earn it on bank accounts, or get back less than they invested in certain bonds when they mature. The concept, though novel and untested, is the most ambitious attempt yet to force banks to lend money and encourage consumers to spend money rather than save it.
An event almost as unusual went largely unnoticed here in the US: the real, or inflation-adjusted, interest rate on the 10-year Treasury bond has gone negative. The 10-year US Treasury yield recently stood at 1.75%, below the 2.3% reading for the core Consumer Price Index, the primary gauge of US inflation. What makes this even more unusual is that, contrary to central bank policy in Europe and Japan, the US Federal Reserve actually raised interest rates in December.
So what is the bond market trying to tell us? In normal times – without such aggressive central bank intervention – the bond market would simply be signaling slower than expected economic growth and lower than anticipated inflation. But these are hardly normal times from an economic standpoint, so there may be more at work than meets the eye.
It’s entirely possible that the move toward negative interest rates in Europe and Japan, combined with the rising value of the US dollar, has prompted large global investors to move money into US markets to improve returns. That would push US bond prices up and interest rates down.
The US Federal Reserve may also be partly to blame. From the moment they raised interest rates in December, bond prices have surged, which is exactly the opposite of what would normally happen when interest rates rise. But the Federal Reserve only controls short-term interest rates and bonds are linked to longer term rates, so investors must believe that higher short-term rates will slow economic growth and cause longer term rates to decline. The Fed itself has supported this view in more recent meetings, explaining that slowing global economic growth suggests further interest rate increases will be limited until economic growth improves.
So it appears that almost everyone agrees that economic growth is slowing, but what about inflation? Is it really possible that consumer prices won’t increase even by 2% annually over the next 10 years? That seems unlikely, although deflationary forces remain strong at the moment. But if the price of oil and other commodities stabilize and rebound, it’s hard to see how inflation could stay low for long, unless that global economy slumps even further.
All of this gives us pause – first, about the bond market, and second, about stock market valuations. If interest rates are unnaturally low as a result of central bank policies, how can it make sense to lock up money for 10 years hoping to earn less than 2%? Yet if the bond market is correct – and bond investors are typically more insightful about economic growth than stock investors – then sluggish growth will continue to crimp corporate earnings, which makes stocks seem over-priced.
Once again, we’re back to hoping that central bankers are today’s super heroes. If they aren’t and prove merely human, we could all be in for a long slog when the bubble bursts.