By Robin Marshall, Director Bond Research, Research & Analytics
When Japanese interest rates first fell towards zero, the Japanese government yield curve steepened sharply as it was assumed temporary, and that interest rates and bond yields would rapidly “normalise” or mean revert at levels more typical of the 1980s and '90s. With about a 20-year lag, the Eurozone now appears to be experiencing the same phenomenon, and has met similar policy responses.
Like Japan, Eurozone policymakers denied there was a deflation threat, or problem with the banking system, and 10 year Bund yields barely moved from 4% in the post-Lehman period, as Chart 1 shows. Investors in Bunds asked “ Crisis, what crisis?”, and the ECB actually raised interest rates in 2010/11 to deal with an inflation “problem”.
US Treasury yields did fall faster after the Fed rushed the policy interest rate down towards zero, but yields rebounded rapidly in 2009/10, reaching 3.5% by 2010. Investor expectations appeared anchored to previous trading ranges in this process. Slowly but surely since then, investors and markets have become accustomed to the “new normal” of lower nominal GDP growth, despite periodic references to an unsustainable “bond bubble ” . Evidence has grown to suggest very low interest rates may be self-perpetuating, and difficult to escape.
There are a number of arguments that support this view.
Trapped in a world of zombification ?
Firstly, low inflation and nominal GDP growth makes it difficult for central banks to raise interest rates for fear of driving economies into recession and inflation expectations down to deflationary levels. Drawing on Austrian capital theory, the period of zero interest rate policy (ZIRP) itself, when interest rates may fall below the marginal product of capital, can “zombify” the economy by allowing companies, and banks, to survive that are not economically viable. This makes it more difficult to raise interest rates without endangering large sections of the corporate economy and banking system. This could explain why labour productivity has been so weak in economies like the UK, where employment levels have been high since 2009, despite weak growth (see Chart 2).
Asset/liability matching trap
Secondly, the financial and regulatory system, in the G7, has strong hysteresis, or linkage to very low interest rates and bond yields, and may drive price-insensitive purchasing of government bonds. Thus, as discount rates applied to future liabilities fall, pension funds and insurance companies with longer term liabilities can be obliged, by regulation, to buy longer dated assets to match these liabilities, even at very low yields. Longevity risk has added to this pressure, as pension fund participants now live longer. Such asset/liability matching tends to flatten yield curves further, and increase the value of future liabilities, so the process may be self-feeding. In the UK particularly, this phenomenon has a long history, dating back to the minimum funding requirement of the 1995 Pensions Act, which required a pension scheme’s assets to cover its liabilities, on a prescribed set of actuarial assumptions.
In complete contrast, during the high interest rate 1980s and 1990s, when nominal GDP growth was stronger, higher bond yields and discount rates, and strong equity market performance, meant defined benefit pension funds were often in surplus. Thus, there was little reason to buy longer dated fixed income assets to match liabilities, due to the favourable combination of higher discount rates for liabilities, and strong performance by investment portfolios in equities. Further, after the banking crisis of 2008/09, banks have been obliged to hold more government bonds for capital adequacy purposes, driving additional demand for government bonds, regardless of price and yields.
Central banks are another price/yield insensitive buyer
Thirdly, central bank QE introduced another price-insensitive buyer into the market for government debt, with some programmes very large relative to the size of government bond issuance (notably the Bank of Japan’s 2013 QQE programme). Quite how large the impact of these programmes has been on government bond yields and the term premium is unclear, with no counter-factual to measure the impact of the purchases, and bond yields sometimes fell when QE was suspended, and vice versa. Most studies have found QE programmes from 2009-14 lowered 10 year Treasury yields by about 100 bp .
Another possible impact of the Fed’s QE has been via MBS purchases, on which the Fed has not managed duration risk, by hedging convexity. This may have led to less selling of 10 year Treasuries, during the upswing in yields, to hedge duration, than typical during a period of rising yields, causing the yield curve to steepen less than in previous cycles of rising rates. Also, the Fed has been buying more Treasuries, relative to MBS, during the period of falling yields in 2018/19, as securities ran off the balance sheet in 2018/19. Powerful though this effect may be, former Fed Chairman Greenspan commented on the “conundrum” of a flattening US yield curve during a Fed tightening cycle in 2005  long before the Fed began QE, and the term premium investors require to hold longer dated debt has been falling steadily, with inflation, since the 1980s (Chart 4).
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 The Great American Bond Bubble, Jeremy Siegel and Jeremy Schwartz, Wall Street Journal, August 18, 2010
 Section 56, UK Pension Act, 1995
 Claudio Borio and Anna Zabai, “ Unconventional monetary policies; a re-appraisal,” BIS Working Paper, 2016.
 Alan Greenspan, Congressional Testimony, February 16, 2005
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