Speculation that the Bank of England will raise interest rates next week distracts us from a more significant fact – that investors expect real returns on safe assets to be negative for years and even decades.
This follows from common sense and simple maths. Common sense tells us that returns on similar assets should be similar. This means returns on (say) a 10-year gilt if held to maturity should be the same as returns on 10 successive one-year bonds, or five successive two year ones and so on.
From this assumption we can infer what the market expects (say) five-year yields to be in (say) five years’ time. It’s simply that yield which would ensure that returns on two successive five-year bonds will be equal to the return on a 10-year bond.
As I write, 10-year index linked gilts yield minus 1.8 per cent, implying a return of minus 16.1 per cent over 10 years. A five-year index-linked gilt offers a return over its lifetime of minus 11 per cent. A five-year bond in five years’ time should therefore give us a return that takes us from a loss to 11 per cent to one of 16.1 per cent. This requires a loss over five years of 6.3 per cent, implying a yield of minus 1.3 per cent.
We can do the same maths for any maturities at any future dates. Doing so tells us that investors expect 10-year real yields to be minus 1.4 per cent in 10 years’ time and to be minus 1.3 per cent in 20 years’ time. All this follows from the fact that the yield curve is relatively flat.
Negative yields, then, are here to stay – if the market is right. It believes that the things that are causing negative yields now – the savings glut, shortage of safe assets and dearth of proper investment opportunities – won't go away.
?Negative yields also suggest that investors don't expect robots to take our jobs
This has devastating implications. It means younger people will need to save more or work longer if they are to have a prosperous retirement, because they cannot rely on decent returns on their wealth to fund their old age.
They can't reliably avoid this by holding equities. Low returns on bonds should also mean low returns on shares. One reason for this is that equity returns should be equal to bond returns plus an equity risk premium. Only if this risk premium will be consistently far above its historic average will we see decent long-run equity returns. Also, investors are holding bonds despite negative returns because they fear economic growth will be low and variable. If they are even roughly right, this is not an environment in which equities will thrive.
If all this is bad news, there is some good.
One concerns the public finances. If real bond yields stay negative then the government will on effect be paid to borrow money. This means that government debt will shrink even if the government runs annual deficits. Looser fiscal policy is therefore compatible with stabilising or even reducing the ratio of government debt to GDP.
Negative yields also suggest that investors don’t expect robots to take our jobs. To see why, imagine we did have a robot revolution. We’d then have high real yields because companies would be borrowing heavily to buy robots, and because returns on financial assets would have to be high to compete with high returns on robotised factories. The fact that investors expect yields to stay low, therefore, tells us that they don’t expect such robotisation. They might be right.
But should we believe the market's forecasts?
It might be that longer-dated yields are low not because investors expect persistently low yields but because pension funds have strong demand for long-dated bonds and this demand is raising bond prices and depressing their yields. In economic jargon, the expectations hypothesis of the yield curve is wrong because some investors have a preferred habitat in the long end of the yield curve.
One fact tells us that there’s some truth in this – that UK real yields are far below the levels of their US equivalents. Even there, though, investors are pricing in low yields for years to come. For example, real 10-year yields are expected to be only 1.1 per cent even by 2027. This tells us that investors believe the era of low yields is here to stay – that what Larry Summers calls secular stagnation is indeed a long-term problem.
Or is it? Maynard Keynes famously warned us of the “extreme precariousness” of expectations of prospective yields. “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible,” he wrote.
The market might well be wrong to expect persistently negative real yields. This, though, still leaves younger people wanting to save for a pension with a massive problem: we simply cannot know what future returns will be and therefore how much to save. For me, this is a big reason why the job of providing for future pensions cannot be done by the private sector alone.
