Get ready for the end of the great bond bull market

Get ready for the end of the great bond bull market
By Joachim Fels
Copyright The Financial Times Limited 2006
Published: September 21 2006 03:00 | Last updated: September 21 2006 03:00


Conventional wisdom has it that the forces unleashed by globalisation have depressed world long-term interest rates in recent years and will keep doing so for many years to come. This view rests on two pillars. The first is an alleged global savings glut - an excess of desired savings over desired investment - fuelled by high savings rates in China and other parts of Asia, which has supposedly depressed real interest rates. Ben Bernanke, US Federal Reserve chairman, is a proponent of this theory. The second pillar is the vast supply of cheap labour in China, India and elsewhere, which weighs on the prices of manufactured goods, keeps inflation subdued and reduces the inflation compensation that bond investors demand when buying long-term bonds - or so the story goes.

However, these pillars rest on shaky analytical and empirical foundations. Yes, long-term interest rates have been exceptionally low in recent years. Yet this is unlikely to have been caused by a savings glut, but rather by a global liquidity glut that is now receding. Globalisation is more likely to push real interest rates and inflation higher than lower in the next few years.

The suggestion of a global savings glut does not sit well with evidence of a roughly unchanged aggregate global savings rate over the past decade. Also, it is difficult to reconcile with the fact that world economic growth has been the strongest in several decades over the past few years. A better explanation for depressed long-term interest rates is that central banks cut short-term interest rates to extremely low levels during the equity bear market of 2000-2003 and the following deflation scare and thus flooded the financial system with excess liquidity. The resulting yearning for yield dragged long-term interest rates lower as investors moved out along the yield curve. Conversely, the progressive normalisation of global monetary policies over the past year or so has already led to rising long-term interest rates.

With global liquidity being withdrawn and real interest rates no longer artificially depressed, other factors should soon start to shape long-term interest rates. Globalisation has made capital scarce relative to the huge supply of labour in the emerging world. Employing this labour will require a larger stock of capital, which implies very high rates of investment in fixed assets for years - infrastructure in India and machinery and equipment in China. Moreover, the larger demand for natural resources caused by rapid growth in the emerging world has raised commodity prices, which will spark higher investment in exploration in commodity-producing countries and in energy-substitution elsewhere. High savings ratios in Asia are likely to fall as income prospects improve and governments build social safety nets. Long-term real interest rates, which balance the demand for and the supply of capital, need to rise, signalling the relative scarcity of capital.

Another sea-change that lies ahead is a rise in inflation towards permanently higher levels than those of the past decade or so. It is increasingly obvious that the big disinflation that started in the 1980s ended in 2002/2003, when inflation had fallen to such low levels that central banks started to consider deflation as their main enemy. They opened the floodgates and reflated first the financial system, then their real economies and now consumer prices.

Moreover, inflation has been depressed since the mid-1990s by several factors that are about to dissipate. Deregulation in many sectors lowered prices, but has largely run its course. The information technology-induced US productivity acceleration, which kept unit wage costs low, is ebbing. Downward pressures on manufactured goods prices from globalisation are waning, too, as higher raw materials prices and accelerating wage costs in China induce exporters to raise export prices. Energy and food prices should continue to be boosted by globalisation, raising headline inflation rates around the world. It will be hard for central banks to keep inflation expectations low. With the output costs of squeezing inflation likely to be high in this new environment, monetary policymakers will probably accommodate moderately high inflation over the next few years.

Against this backdrop, investors, companies and governments should prepare for an end to the great bond bull market that has lasted almost a quarter of a century. It is unlikely to usher in a bear market of 1970s dimensions. But in a few years, the low bond yields of recent years will look like an anomaly rather than the norm.

The writer is managing director and chief global fixed income economist at Morgan Stanley