Global savings glut suppresses bond yields

Demographics is destiny. This may be a truism for political scientists, but investors ignore the implications at their peril.

At the moment, investors are desperately trying to divine when and how quickly the Federal Reserve will begin to raise interest rates, and the impact on bond markets. The consensus is that any turbulence will be transitory, and bond yields will continue staying “lower for longer”. But don’t bet on them staying low for ever.

 

One of the most notable developments in global markets in recent decades is the inexorable march downwards in bond yields. Since Paul Volcker’s Federal Reserve broke the back of inflation in the 1980s by aggressively hiking interest rates, bond yields have fallen steadily to unforeseen, record-breaking lows — almost irrespective of where the Fed’s main policy rate has been set.

This is partly a result of dissipating inflation, the historical nemesis of fixed income. More recently, extraordinary monetary stimulus has suppressed yields further, driving investors into bonds, with pension plans and insurers major buyers of long-term debt.

But according to many economists, it is also a product of a “global savings glut” from baby boomers stashing away their earnings for their retirement, and developing countries building up their reserves. This has lifted demand for bonds and subduing borrowing costs in the process.

This hypothesis was first articulated by former Federal Reserve chairman Ben Bernanke in 2005. He recently revisited the thesis in a blog post at his new home at the Brookings Centre, arguing once again that the savings glut is a leading cause of low bond yields, not just central bank interest rates or quantitative easing.

According to recent research from Michael Gavin at Barclays, the savings bonanza could account for about 2 percentage points of the decline in the “natural” real interest rates — adjusted for inflation and the economic cycle — over the past three decades, from about 2 per cent in the 1980s to roughly zero today.

But this is unlikely to last. western baby boomers have started retiring and in the coming years will draw down their savings, as the number of working-age people declines.

The developing world is unlikely to be of much help. HSBC’s Karen Ward estimates that emerging economies will add 330m more “peak savers” by 2030, but reckons that this capital is now less likely to flow into western financial markets. “The baby boomers’ twilight years may not be so golden after all,” she warns.

Quantifying the impact is tricky. But Mr Gavin estimates that all things being equal the natural real interest rate will rise by about 1 percentage point over the next five years, 2.25 percentage points over the next decade, and 3.5 percentage points over the next two decades.

Even this may underestimate the coming rise in longer-term bond yields, given that they are currently well below the natural rate thanks to the extraordinary monetary stimulus unleashed by central banks led by the Fed in the wake of the financial crisis. Like a balloon held below water, it may snap higher when finally released.

Equity markets are also likely to be rattled. Niels Jensen of Absolute Return Partners pointed out in a recent letter to clients that middle-aged workers tended to favour stocks, but shifted sharply into bonds when retirement loomed. “What has been a tailwind for many years is likely to turn into a sizeable headwind in the foreseeable future,” he warned.

Still, nothing is set in stone. The financial crisis and the uncertain future facing many pension plans could lead to a long-lasting shift in attitudes towards thrift. How savers respond to shifts in interest rates remains unclear. Countries could also respond to the demographic challenges by lifting retirement ages or becoming more receptive to immigration.

Japan is the canary in the coal mine. Its household savings rate has declined in tandem with the average age, which is now the highest in the world. But so far there is no discernible impact on the Japanese bond market. Corporate savings have climbed as investments have dipped, and the Bank of Japan’s QE programme has pinned down yields.

But the forces of demographics move slowly, and it will take years — possibly decades — before any impact becomes apparent.

Source: http://www.ft.com/intl/cms/s/0/fda6e646-e4d1-11e4-8b61-00144feab7de.html#axzz3XmTZNo6e