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OPINION

The surprise fall

The surprise fall
December 11, 2014
The surprise fall

This is especially surprising because three things have happened this year which should in theory have raised yields - two of them expected and one less so.

One is that the Federal Reserve has finally ended quantitative easing. Another is that the UK and US economies have continued to grow. This should have encouraged investors to take more risk and so should have reduced demand for safe assets.

On top of this, and less expectedly, oil prices have fallen. This should have reduced demand for index-linked gilts simply because it reduces the chances of high inflation, and this should reduce demand for insurance against inflation.

Why, despite all this, have real gilt yields fallen?

One reason might be that Chinese buying of US Treasuries has increased to offset reduced buying by the Fed: in the 12 months to September, they bought a record $163.8bn of them. This should have helped gilts simply because gilts are a close substitute for Treasuries and so prices of the two should move together.

More significantly, perhaps, the weak euro area economy has reduced yields around the world not only by increasing demand for safer assets but also by fuelling hopes that the ECB will eventually begin to buy government bonds.

There might, however, be two longer-term factors behind this year's fall in yields.

One - which has been emphasized by the MIT's Ricardo Caballero - is that there has been a global shortage of safe assets. The IMF estimates that the world has generated £12.5 trillion of new savings this year. Many savers want a safe haven for this money. But the global supply of such assets - top quality bonds or government-guaranteed bank deposits - has not kept pace with demand. And when demand exceeds supply, prices rise - which means falling yields.

A second factor is secular stagnation. If investors expect real growth to be low around the world, they'll buy government bonds - both because they anticipate low short-term interest rates and hence low returns on cash, and because they'll want assets that usually do well in recessions.

There's one overlooked fact which suggests that fears of secular stagnation are stalking markets. It's that growth stocks haven't done especially well. In principle, falling long-term interest rates should be fantastic for such stocks, because they mean that future cashflows are discounted less heavily - and growth stocks, by definition, offer lots of future cashflows. However, so far this year the FTSE 350 low yield index has only marginally beaten its high yield counterpart, returning 3.7 per cent against 3.1 per cent. This would be consistent with the benefit of a lower discount rate being offset by lower growth expectations - which is just what secular stagnation implies.

All this poses the question: what might change to raise real yields?

One possibility would be a recovery in the euro area. Another might be a diminution in the safe asset shortage. This could happen if falling oil prices reduce oil exporters' excess savings and hence demand for western bonds.

However, there's a big unknown here: will secular stagnation (or fears thereof) intensify or weaken?

What would reduce fears of stagnation would be signs of more monetizable technical progress. Such signs would increase hopes that businesses will step up their investing, which would divert savings from safe assets into capital spending, and would also increase expectations for future real growth.

We cannot, however, say whether this will happen with any confidence simply because, as Columbia University's Jon Elster has said, technical progress is "fundamentally unpredictable" - because if we really knew what the next big invention would be, we'd have already invented it ourselves.

To this extent, the future of gilt yields is genuinely unknowable. And this suggests a two-fold case for holding onto index-linked gilts. Not only could their yields get even lower, but also they protect us from what is a nasty risk to equities - the risk that fears of secular stagnation might actually intensify further.