ALAN GREENSPAN confessed last week that, along with the Federal Reserve Board’s army of PhD economic researchers, he was baffled by the low level of long-term US interest rates. Similar expressions of puzzlement could be heard throughout the past few months from British officials and financiers, as government bond yields have remained firmly stuck in the 4 per cent to 4.5 per cent range, while short-term interest rates march upwards and economic expansion becomes more firmly established, not only in the Anglo Saxon countries but around the world.
The almost universal bafflement among the world’s top economists and central bankers about what Mr Greenspan described as the “conundrum” of surprisingly low bond yields in a period of robust economic growth and tightening monetary policy, is one reason why I have stuck firmly to my belief that the bond market’s recent behaviour reveals nothing worth knowing about the outlook for the world economy. Many analysts believe that the recent decline in long-term bond yields suggests a risk of recession, especially in the US economy, during the year or two ahead. But this view seems plain wrong.
As Mr Greenspan remarked last week with the felicity of phrasing which he reserves for his more important pronouncements, the bond analysts’ prediction of an imminent recession “does not mesh seamlessly” with the rise in equity prices, the narrowing of credit spreads and the widespread improvements in business confidence, all of which point to improving business conditions and strong global growth. Indeed, the real “conundrum” about today’s bond market may well be why so many analysts and investors continue to believe in theories about a debt-induced recession that have repeatedly been proved wrong.
A few months ago Mr Greenspan offered one persuasive explanation when he suggested that investors who continued to ignore the inevitability of ever-higher US interest rates in a period of global economic recovery were “obviously desirous of losing money”. But with the aberrational behaviour of bond investors apparently continuing, this explanation is no longer good enough. After all, the long-term government bond yield is the single most important financial variable in any market economy, setting the tone for equity and house prices, governing business investment decisions and establishing the discount rate for pension liabilities and insurance policies. It is therefore worth trying to think a little more deeply about the possible reasons why rational people continue to lend money to the US government at yields of only slightly over 4 per cent for ten years.
In last week’s speech, Mr Greenspan considered three familiar explanations: First, there was the “subdued demand for business credit”, since companies are enjoying bumper profits and simply do not need to borrow to invest. Secondly, the “heavy purchases of Treasury securities by foreign central banks”. Last year foreign central banks bought a net $236 billion (£125 billion) of US-issued securities, of which $203 billion were US government bonds. These official purchases alone were enough to finance almost half of the US Government’s budget deficit and fill one-third of the country’s trade gap. Thirdly, there was low and stable inflation. But as Mr Greenspan said, these arguments cannot really explain the recent decline in bond yields. Both business cash-flows and foreign official purchases were even stronger in early 2004 than they are today. As for inflation, the real long-term interest rate on inflation-linked government securities, has recently fallen even more than the nominal rate.
It seems to me, however, that there are two other structural factors which Mr Greenspan did not mention, but which may be exerting even stronger downward pressure on long-term interest rates around the world. The first is liability-matching by pension funds and insurance companies. The second is the behaviour of Japanese private investors.
Let me begin with Western insurance and pension funds. These have been driven by regulatory pressures and fears of litigation to “immunise” their long-term liabilities by buying bonds, regardless of price. Many businesses no longer treat their pension funds as profit-maximising investment operations, but as balance-sheet entries designed to minimise accounting risks. Such companies pour their pension payments into bonds without regard to prospective returns. If bond prices fall, they reason, long-term interest rates will go up and this will reduce the capitalised cost of pension liabilities. Thus there appears to be no business risk in allocating pension fund assets to bonds, almost regardless of the yields they offer. This herd-like behaviour by pension funds is exactly analogous to the stampede into technology shares in the late 1990s, on the grounds that these shares dominated the S&P 500 or FTSE index. Buying Microsoft or Vodafone, regardless of underlying value, exposed fund managers to no business risk because the fashion for indexation ensured that their competitors did the same thing.
Life insurers are becoming similarly yield-insensitive as regulators restrict the use of investment performance in selling their products. If the FSA prevents life insurers from competing on the basis of their past investment performance, then insurance becomes a pure marketing business: everyone sells the same policies based on whatever happens to be the prevailing yield on government bonds. If yields jump from 4 per cent to 6 per cent next year, then insurance companies will simply offer better terms to next year’s investors. But given the decline of investment competition, they do not need to worry about the implicit capital losses suffered by customers who buy policies based on today’s unsustainably low yields.
An even bigger influence on global bond yields than the indifference to price among highly regulated Western institutional investors, may be the interests of Asian private savers, especially the Japanese.
The Asian private sector is a huge buyer of US and European bonds, far bigger than the Asian central banks. According to the US Treasury’s investment statistics, foreign private investors bought $655 billion of US-issued bonds in 2004, three times the official purchases of US bonds. By far the most important group of foreign private investors have been the Japanese, either investing directly through foreign bond funds which are increasingly popular among Japanese retail savers or indirectly through Japanese life insurers and trust banks.
Why have the Japanese been buying so many US bonds? There are two common explanations. One theory says that Japanese banks and insurers act on “guidance” from the Ministry of Finance, designed to assist the Government’s protectionist efforts to keep the yen as weak as possible.
Another view maintains that Japanese investors are simply stupid: they find yields of 4 per cent plus on foreign bonds irresistible in comparison with Japan’s yields of less than 2 per cent, but that is only because they fail to understand the nature of currency risk. After all, the yen strengthened by 10 per cent against the dollar in just five weeks last autumn. That seems enough to wipe out four or five years’ worth of the income-differential between Japanese and US bonds.
Until recently I have accepted the conventional view of Japanese private investors as either protectionist or stupid. But a more respectful view may be appropriate. Maybe the foreign-exchange risk faced by Japanese bond investors is actually much less severe than we in the West believe. The essential point is that Japanese investors, like the Western pension and insurance funds, do not need to mark their assets to market or recognise paper losses.
Imagine an elderly Japanese retiree, with cash savings of Y100 million at a time and suppose for simplicity that the exchange-rate is $=Y100. Suppose, further, that our Japanese saver wants only to secure the best possible pension for his remaining 20 years of life, leaving nothing as a legacy to his children. He can do this by buying an annuity, backed by bond investment either in yen or in dollars. Looking up the annuity tables we find that a yen annuity, based on today’s 20-year yen bond yield, would pay 6.1 per cent annually (including both interest and return of principal). A dollar annuity, based on the 20-year dollar yield would pay 7.9 per cent.
Since the yen annuity pays 23 per cent less than the dollar annuity, the Japanese dollar pensioner will be better off provided the dollar falls by less than 23 per cent on average over the next 20 years. Assuming a straight-line decline from today’s Y105 to the dollar, the break-even exchange rate by 2025 is Y57. Will the dollar fall below Y57 by 2025? It could; the dollar’s value against the yen did halve between 1985 and 2005. But given the demographic structures of the US and Japanese economies, another halving of the exchange-rate seem unlikely. Thus Japanese buying dollar bonds, even at the present overvalued levels, may not be as stupid as it seems.
This does not mean that dollar bonds are good value in the light of US economic fundamentals. But it may mean that US long rates remain “surprisingly” low as long as Japanese interest rates stay near-zero — which is extremely likely for many years to come.
