• Interest rates traded on financial markets have risen over the past month;
• But by historical standards they remain very low;
• The state of the economy only partially explains the level of rates;
• Some factors keeping rates low are temporary, some are likely to be more permanent.
Interest rates rose over October and into the start of November. Two-year government bond yields rose by over quarter percentage point, ten-year interest rates by a little more. The rise mainly reflected global events. The economic data had been a little better than expected. There are indications that both the ECB and the US Federal Reserve have finished (at least for now) reducing interest rates.
Leaving aside the monthly financial market zigs and zags the big picture is that the level of rates both domestically and globally are at historically low levels. The cash rate in Bank of England is around its lowest level in over 300 years. Australian Government bond yields are near their all-time low.
Australian Government Bonds 10 Year Yields
Bank Of England Cash Rate
Why are interest rates so low? The obvious place to start is the current state of the economy. In Australia the underutilization rate (unemployment rate plus those working part-time who would like a full-time role) is above the level seen in the pre-GFC days as the economy has not been strong enough for long enough. Other countries have also suffered from an underperforming labour market. But in about half the OECD countries underutilization rates have fallen below their pre-GFC lows.
Another factor behind low interest rates is that inflation is below central bank targets in many countries, notably Japan and much of Europe. This is also the case in Australia. Only in the US, Canada and a couple of European countries is inflation close to target.
Underutilisation Rates In OECD
(difference between 2019 and cyclical low)
Core Inflation Rate For Selected Countries
(difference between 2% and June 2019 data)
But the cyclical state of the economy can only provide part of the answer. In the late 1990s when inflation was around its current level and the unemployment rate was closer to 7% the level of the cash rate started with a 4.
There has been increasing discussion as to what has driven interest rates so low, including a speech by the RBA Governor. There is growing agreement that low rates reflects a combination of lower demand to borrow funds and an increase in the supply of funds. Most factors identified are global.
Increased supply of funds
The first factor driving interest rates lower is the rise in global saving. Saving rates in developed countries have declined a little since the 1990s. But over that time there has been a big rise in saving rates in Asia, a period when that region has become a bigger part of the global economy.
Developments in China have been important. A growing proportion of rising Chinese incomes have been saved. Partly that reflects an underdeveloped financial sector that has historically favoured large borrowers (notably governments and government-connected firms). Households (and small businesses) have needed to save if they wished to undertake any investment (such as buying a house).
The Government ‘safety net’ has also been more limited than in developed countries so households have had to save to meet education or health demands. The lack of government benefits has been particularly marked for internal migrants moving to larger cities that have not been able to receive residency status.
Things are changing. Chinese banks have begun to lend more to small business and households. Loans to those sectors are still a relatively small component of total credit (albeit rising). But RBA calculations show that the household debt to GDP ratio in China is approaching European and Japanese standards despite China having a lower income level. Small firms report that bank lending conditions are currently easier than experienced by larger firms.
The Government has also been increasing the range of benefits available to the population and made it easier to move to cities. The result has been a reduction of saving rates in China over recent years. Further policy changes will be necessary to achieve a further decline in saving and allow China to achieve its goal of becoming a consumption-driven economy.
National Saving Rate
Regions As Proportion Global Economy
Loan Demand In China
(survey of bankers)
Housing Loans Made By Chinese Banks
(% total assets)
Another reason behind the increase in global saving is that the large amount of debt outstanding has made borrowers cautious. For example, Governments around the world worried about their large debt burden kept a tight rein on their spending post-GFC. The high level of household debt in Australia has played a role in the increasing caution amongst consumers. Company dividend payout ratios have risen partly as a result of firms becoming risk averse about the economic outlook.
(bank deposits + payoff debt)
US Government Debt Held By Public
(% of GDP)
Total Global Debt
(% of GDP)
Implied Dividend Payout Ratio Australian Firms
There has also been a change in the composition of saving that helped drive interest rates lower. Weak global growth and concerns about financial market risk aversion has led to central banks buying a growing proportion of government bonds helping to drive down interest rates. And lower government bond yields has resulted in reduced yields on other assets.
Regulatory and risk management changes have also created additional demand for bonds from banks, pension funds and insurance companies. The macroeconomic environment (weaker than expected growth and low inflation) has also created a demand for bonds.
Ownership Of US Treasury Market
(federal reserve + banks + life insurance + pension funds proportion total)
Proportion Of Japanese Government Bonds Owned By The Bank Of Japan
Global Fund Manager Portfolio Weightings
Foreign Currency Investments
(% Swiss National Bank total asets)
On the demand side slowing population growth (and an aging population) is likely to reduce the need for investment. Slowing population growth means there is less demand for roads, bridges and housing. There is evidence that in countries with slowing population growth and aging population (such as Japan and Korea) there has been a trend decline of business investment.
Weakening productivity growth also has played a role as it leads to slower income growth and therefore reducing countries ability to invest. There may also be an element of chicken-and-the-egg as the downturn of business investment over recent years has played a role in the weakening of productivity growth.
World Population Growth
(annual % change, 5 year average)
Aging World Population
(65+ proportion total population)
US Productivity Growth
(output per hour annual % change, 5 year average)
Another reason for lower investment has been an increase in uncertainty about economic policy over recent years. Post the GFC uncertainty increased reflecting worries about the economic and financial market outlook. In more recent years a wide variety of issues have created uncertainty, including the Trade and Technology War between the US-China, Brexit and the Japan-South Korea trade spat.
Changes in regulations and risk management practices have led to banks reducing their funding reliance on borrowing from financial markets. Borrowing has also been reduced by the tightening of lending standards in a number of countries (partly offset by a rise in lending by the non-banking sector).
Level Of Uncertainty In The US About Economic Policy
(standard deviations from average)
Change In Debt Sector Of The Global Economy
(change debt % GDP 2009-19)
Factors Limiting Production European Manufacturer's Financial
(% of respondents)
Australian Bank Loan To Deposit Ratio
Another reason for a lower demand for borrowing is that a rising proportion of investment in recent years has been either been IT or intangibles. Firms are less likely to borrow for these type of investments (partly also because of the lack of collateral to lend against).
IT & Intellectual Property Investment
(% total business investment)
Reasons Need Debt Finance
Both supply and demand factors have driven interest rates to historically low levels. Some of the factors will change. A big fiscal response could get the domestic and global economies moving. As China moves towards a consumption-driven economy it will save less. Low interest rates are making it easier to repay debts and so in time borrowers will feel comfortable to borrow and spend again. At some stage central banks will play a smaller role in bond markets. When this happens fund managers may also reduce the level of their bond holdings. Politicians play an important role in determining the level of uncertainty about policy.
But some trends are long-lasting. Most notably slowing global population growth (and an aging one) will continue to play a role in keeping rates low. IT and intangible investment is only likely to grow in importance.
What this means is that interest rates will at some stage rise again. Developments in China and what happens with fiscal policies are likely to be the big swing variables. But unless inflation starts to increase substantially the level of interest rates will remain below the levels seen in the pre-GFC salad days.
We live in interesting times!
Peter Munckton - Chief Economist