Minouche Shafik: Interpreting the yield curve - warning or opportunity?
Speech by Ms Minouche Shafik, Deputy Governor for Markets and Banking of the Bank of
England, at the Association of Corporate Treasurers Annual Conference, Manchester,
22 May 2015.
* * *
Accompanying charts can be found at the end of the speech.
The views in this speech are my own, and not those of the Bank of England or the Monetary PoIicy Committee. I
would like to thank Ben Broadbent, Ronnie Driver, Kristin Forbes, Grellan McGrath, Martin Weale and Chris
Young for their comments.
It is a pleasure to be here. I would like to talk today about long term borrowing rates - a topic
that I am sure is often on the mind of a corporate treasurer. I have been thinking about this
issue since I joined the Monetary Policy Committee (MPC), as not only are long yields an
important input to current financial conditions, but - carefully interpreted - they can offer an
insight on future developments too. I have been waiting to find a group who might be as
intrigued by it as I am, so I jumped at the chance to speak to the Association of Corporate
Treasurers.
The yield on nominal 20-year UK government debt peaked at around 17% in 1974. After that
long term yields began a period of decline which continued right up to the mid 2000s
(Chart 1). The move was part of a global trend which reflected large macroeconomic forces,
including: an increasing share of the global population being of prime working age; the rise of
global inequality; the adoption of inflation targeting over the course of the 1990s; and the
global imbalances that emerged in the early 2000s in which a glut of savings from emerging
economies flowed to advanced economies.1 Pension reforms in the UK - also over the
course of the 2000s - created a further incentive to invest in long-dated bonds to better
match defined-benefit liabilities.
Of course since then we have had the global financial crisis and its aftermath, during which
long yields declined further, reaching new lows in the first months of this year. More recently
we have seen some quite sharp moves higher. But on any historical comparison long term
interest rates are still at exceptionally low levels. How should we interpret them?
A starting point is the pure expectations hypothesis, which says that the long term yield
should reflect the market's expectation of the average short term yield over that period. If that
is true, then it suggests that Bank Rate is expected to average 21⁄2% over the next 20 years
(about half of its pre-crisis average of 5%). From that it would be easy to infer that financial
markets are expecting either very low investment and growth, or very low inflation, or both.
As Chart 2 shows, long-dated corporate borrowing rates have followed much of the
downward move in government bond yields over recent years. Whether you believe this is
reflective of the prospect of gloomy days to come or the result of some other factors will
determine whether you - as corporate treasurers - view very long low yields as a warning or
an opportunity.
In the rest of my remarks I will cover four possible explanations for the current level of long
yields:
(i) lower inflation expectations;
(ii) the balance of savings and investment intentions;
(iii) diminished potential output growth; and
(iv) reduced term premia
I will argue that it would be overly pessimistic to believe that the headwinds currently
affecting the nominal and real economy will persist for decades to come. But I will also argue
that there are other influences on long yields affecting saving and investment decisions
(including the persistent-but-not-permanent effects of a balance sheet recession, and greater
weight being attached to downside risks) and on term premia (including the impact of central
bank asset purchases).
2. Inflation expectations
Let me start with inflation expectations. Because some of the decline in nominal yields over
recent years coincided with a marked and unexpected decline in headline inflation in the UK,
a natural question to ask is whether or not this was caused by a shift lower in inflation
expectations. Indeed as a monetary policy maker, that is perhaps the most important
question to ask.
Judging by the behaviour of measures of inflation expectations derived from index-linked
gilts, markets are attaching a low probability to the idea that the current weakness in inflation
will prove permanent.
Market-implied measures of long-term inflation expectations have been remarkably stable
over the period in which inflation has declined (Chart 3).
That is consistent with the MPC's view that the majority of the decline in inflation over the
period since the middle of 2013 can be accounted for by factors that are unlikely to have
permanent effects on inflation. There has been a 44% decline in the price of oil from its peak,
and a 17% appreciation of sterling since early 2013, and such phenomena can be expected
to have large - but not permanent - effects on prices of consumer goods. The most
important determinant of inflation at the horizon the MPC is concerned with is domestically
generated inflation. And measures of domestically generated inflation (such as unit wage
costs, Chart 4) have stayed relatively stable during the period in which headline inflation was
declining.
But what is a little puzzling is that, given the growth of the economy in recent years and the
associated decline in economic slack, measures of domestically generated inflation have not
picked up as quickly as we would otherwise have expected. For example, although
unemployment has moved more than three quarters of the way from its peak back towards
what we might consider its equilibrium rate, unit wage cost growth is still just over one third of
its pre-crisis rate.2
There are a multitude of possible explanations for this. But one I put weight on is that, in light
of six years of very weak wage growth, workers are not quite confident enough to demand
the kinds of wage increases which would have been the norm in the years prior to the crisis.
Were the recovery in wage growth not to materialise and inflation to linger far below the 2%
target for longer than currently embodied in the MPC's forecast, it would be a very
undesirable outcome. It would prolong the headwind from deleveraging that I will come on to
discuss, and potentially result in higher real interest rates than would otherwise be
appropriate. And the MPC has underlined its commitment to avoiding such an outcome.3
However, recent data have been more encouraging. And as workers become more confident
over the coming years, I would expect wage growth to continue to pick up. There is already
anecdotal evidence that the tightening labour market has made recruitment and retention
concerns a source of upward pressure on labour costs. So it is reasonable to expect that
once a significant minority of firms has offered a return to pay growth that is more normal by
historical standards, we can expect the majority to follow.
3. The balance of savings and investment intentions
Let me turn to the balance of savings and investment.
Although many believe that the MPC sets interest rates, that is only strictly true for short term
rates, and even then only the rates applicable in our monetary and liquidity insurance
operations. Long term interest rates are set by the economy, and must ultimately equilibrate
the desire to save and the desire to invest. Much of the decline in interest rates over the 30
years prior to the crisis represented large global forces - as evidenced by the tendency of
international bond yields to co-move.4 Demographic effects, for example, saw the proportion
of the global population in prime working age increase from 50% to 58%.5 Those in the
workforce tend to save more than those outside it, particularly over a period of increasing life
expectancy. The rise of inequality has also had an impact through its tendency to skew
income toward those more likely to save.6 Needless to say, the development of these trends
over the coming decades will continue to play an important role in the determination of long
term interest rates.
But it is the further decline in interest rates since the crisis7 that I am focussed on today, and
it suggests a further shift towards a desire to save rather than invest over that period, driven
by forces other than those long-running trends.
There are (at least) three interpretations of this further shift:
The first is that market participants (ultimately representing the interest of savers
•
and investors) believe that the cyclical forces which currently warrant very low levels
of Bank Rate will persist for decades to come. Put another way, that we are entering
a period of secular stagnation or chronic demand deficiency.8
• The second is that what we are witnessing is typical of a "balance sheet recession".9
As we know, recessions that are preceded by a large build-up of credit tend to be
followed by more severe and prolonged downturns.10 One reason is that economic
actors tend to focus on reducing debt levels to the detriment of projects that would
otherwise be expected to have a positive net present value. In such a situation the
interest rate required to clear the market for savings and investment can be very low
indeed.
• The third interpretation is that financial market participants do not have a particularly
gloomy central expectation for the path of the economy over the coming decades,
but they do attach significantly more weight to the downside risks than they did prior
to the crisis.11
This would reduce long yields in two ways: by making firms less confident about the
future payoff from their investment projects, thus requiring a lower level of interest
rates to incentivise them to invest; and by making savers demand a higher credit
premium to lend to the private sector, thus driving a wedge between risk free rates
and other interest rates in the economy.12
My own view is that most of the headwinds that have buffeted the global economy over the
period since 2008-09 do bear the hallmarks of a balance sheet recession in which the
impetus to reduce debt is the force driving agents behaviour: first by financial institutions who
reduced the supply of credit to the real economy; then by the businesses and households
who simultaneously became more pessimistic about the outlook and reassessed their need
to maintain their own stock of liquidity. When public sector balance sheets reached their
limits, it was the turn of deleveraging at a national level through fiscal consolidation, a
process which is likely to continue for some time to come in the UK and euro area.
It would be overly pessimistic to have as one's central case that the headwinds currently
affecting the economy will persist for decades to come. Although they will be persistent, they
will not be permanent. Indeed there are now nascent signs that some of these headwinds
have already begun to ease. For example, against a backdrop of improved confidence in the
recovery (Chart 5), firms have slowly but surely been increasing the amount they invest
relative to the amount they save (Chart 6). And household saving has also declined from its
very elevated precautionary levels.
But that is not to say that it is imprudent of financial markets to attach weight to the downside
risks - they are real. Indeed, reducing the probability of those risks materialising has been a
driving factor in the MPC's decision to maintain Bank Rate at its historically low level of 0.5%
for 6 years, and the committee's guidance that when Bank Rate does begin to rise, it is
expected to do so more gradually than in previous cycles, and is expected to remain below
average historical levels for some time to come.
4. Diminished potential output growth
Let me turn next to potential output growth. When one thinks about the distant future - that
is, the period beyond the influence of the current set of cyclical factors - one tends to think
that interest rates will tend toward a level that reflects the rate of return on investment, and
hence the potential output growth of the economy.
Potential output growth matters a great deal for monetary and macroprudential policy. In the
long run it determines the rate at which the economy can grow without generating
abovetarget inflation, and it determines the rate of income growth in the medium term, and hence
the sustainable level of debt today.
During the financial crisis, we rediscovered the fact that recessions accompanied by financial
crises tend to be followed by a sustained fall in the level of potential output.13 The only silver
lining was that although the level of potential output tended to be permanently lower, the
growth rate could be expected to recover.
However, if the current yield curve can be interpreted as an indicator of financial market
participants' expectations of the return on investment in the long term, it suggests they are
sceptical that potential output growth can even return to pre-crisis norms. For example, the
10-year real rate beginning in 10-years' time implied by current government bond yields
is -3⁄4%. The comparable number over 2000-2006 was +12⁄3%. And even during the height of
the financial and euro area crises over 2008-2012 it was +3⁄4%. (Chart 7)
In the long term, the most important determinant of potential output growth is productivity
growth, which is in turn determined by the rate at which new ideas are generated and
implemented. And given the very disappointing productivity performance of the UK over the
past 7 years, it would perhaps be understandable were financial markets to have lost hope
that productivity growth would ever return. Perhaps they agree with those who argue that
recent innovations cannot contribute as much to productivity growth as historical ones such
as the electric light bulb, the internal combustion engine and indoor plumbing once did.14
Human history has had many periods in which pessimism about innovation and technological
progress has been proven wrong, dating at least back to Malthus. There is much by way of
exciting innovation that has yet to be fully exploited.15 3D printing is transforming the R&D
process by vastly increasing the capability to produce prototypes. Advanced robots are being
developed that will allow increased precision and safety in their use, thus increasing our
ability to automate many routine activities. Firms are learning how to harness the power of
Big Data, which will allow them to personalise their products better and reduce waste.16
The Bank of England is playing its part to in the wider effort to ensure that productivity growth
can resume, by taking steps to ensure that the financial system will be well placed to
facilitate the implementation of these ideas, and the allocation of resources across the
economy more generally. For example, much of the work of the Financial Policy Committee
(FPC) in the years since the financial crisis has been focussed on ensuring that the banking
system is resilient and well-capitalised. And the FPC is pursuing a medium-term objective to
ensure that there are diverse and resilient sources of market-based finance to complement
the banking sector. This is borne out in the improvement in the availability of credit to
companies such as yours, which our agents tell us has been easing across the board
(Chart 8).
The combination of an impressive stream of ideas, and a financial system stable enough to
facilitate their implementation means I am reasonably confident that productivity growth will
return at some point. Moreover, I think it is reasonable to expect that resumption in
productivity growth to come over the next year or so as the continued narrowing of slack in
the labour market raises the incentive to increase output by increasing output per worker. But
- as many a forecaster of productivity has learned - picking exact inflection points for
macroeconomic variables can be difficult, so the degree of uncertainty around the timing of
this is high.
5. Term premia
Thus far the explanations I have covered have ranged from transient, to cyclical to structural.
Let me turn now to the unobservable.
Economists refer to the factors which move the yield curve in addition to the expected path of
rates as "term premia" - the (positive or negative) compensation that investors require to
invest in a longer dated security in addition to the returns that could be expected from rolling
over short term investments.
Because they are by their nature unobservable, term premia must be estimated. Chart 9
shows one estimate of the effect of term premia on UK government bond yields over the
period since August of last year, using a technique based on that of Adrian, Crump and
Moench (2013). More information about how these estimates are arrived at will soon be
available on the Bank's forthcoming staff blog, but the main message is that over this period
term premia were a big driver of the move lower in yields.
There are several potential practical developments that one could attach to declining UK
term premia. One that has featured heavily in our market intelligence gathering is spillovers
from international monetary policy actions.17 In August of last year, financial markets began
to anticipate that the European Central Bank (ECB) would embark on a programme of asset
purchases, and it has subsequently announced that it intends to expand its balance sheet by
€1trn over the coming 18 months. Of course this action is not exogenous - it is itself a
reflection of the headwinds facing the euro area economy. Between the ECB and the Bank of
Japan (which is continuing its programme of Qualitative and Quantitative Easing announced
in early 2013), central banks will purchase the equivalent of around $125bn worth of assets
per month between now and September 2016 (Chart 10). You could say that the quantitative
easing baton has been passed from the UK and US to the ECB and BoJ.
That these large flows (or the anticipation of them) would have spillover effects on borrowing
rates in the UK should not be a surprise. The ECB and the BoJ purchases will be equivalent
in value to all of the net issuance by advanced economy governments over the next 18
months. And given that UK government bonds and other government bonds are (to varying
degrees) substitutes, it is natural to expect their prices to co-move - in much the same way
that if the ECB were to buy $1trn of Eurozone butter we might expect the price of British
margarine to increase.
By much the same logic, it is plausible that the recent move higher in both Eurozone and gilt
yields is an unwinding of some of the initial price effects that followed the commencement of
ECB quantitative easing.
6. Conclusion
Long term yields have always been the product of big global macroeconomic forces. Their
structural decline in the thirty years prior to the crisis, for example, reflected the adoption of
inflation targeting by many countries, global demographic trends, and the imbalances of the
early 2000s in which a "glut" of savings flowed from emerging economies to advanced
economies.
Large forces have also played a role in the aftermath of the financial crisis, a period during
which long yields have declined further. It seems likely that this move has been driven by
factors including a persistent-but-not-permanent drag from deleveraging, increased weight
being attached to downside risks, and the ongoing impact of quantitative easing programmes
across the globe. These are legitimate reasons for long yields to be low, but should not be
mistaken for a gloomy prognosis of long-term growth and inflation prospects in the UK.
That is not to say that we should ignore the potential signal from long yields. There is a risk
that the nominal and real effects of the financial crisis prove more persistent than this central
case, and monetary policy has an important role to play in reducing the probability of such an
outcome. Indeed, doing so has been my primary motivation in not voting for an increase in
Bank Rate over my first 10 months on the MPC. But it seems to me most likely that: first, the
factors currently pulling down on headline inflation will not do so permanently; second, the
headwinds currently affecting demand in the economy will continue to gradually ease over
the coming years (facilitated by accommodative monetary policy); and third, a return to
productivity growth will facilitate potential output growth over the long term.
So while we on the MPC should heed some of the warning implied by low yields, you should
seek out the potential opportunities they offer.
References
Barro R (2006) Rare disasters and asset markets in the twentieth century, The Quarterly
Journal of Economics 121 (3).
Bernanke B (2005) The Global Saving Glut and the U.S. Current Account Deficit, Sandridge
Lecture, Virginia Association of Economists, Richmond VA.
Dynan KE, Skinner J and Zeldes, SP (2000) Do the rich save more? NBER working paper
No. 7906.
International Monetary Fund (2009) What is the damage? Medium term output dynamics
after financial crises, World Economic Outlook, October, Chapter 4.
King M and Low D (2014) Measuring the "world" real interest rate, NBER working paper
No. 19887.
Koo R (2014) Escape from balance sheet recession and the QE trap, Wiley.
Malik S and Meldrum A (2014) Evaluating the robustness of UK term structure
decompositions using linear regression methods, Bank of England working paper No. 518.
McKinsey (2013) Disruptive technologies: Advances that will transform life, business and the
global economy, https://shar.es/1rwoVu.
Mokyr, J (2014) What today's economic gloomsayers are missing,
http://on.wsj.com/1w66q1z.
Rey (2013) Rey, Hélène (2013) Dilemma not Trilemma: the Global Financial Cycle and
Monetary Policy Independence, Proceedings - Economic Policy Symposium - Jackson Hole,
Federal Reserve Bank of Kansas City.
Rogoff (2015) Debt supercycle, not secular stagnation,
http://www.voxeu.org/article/debtsupercycle-not-secular-stagnation#.
Summers L (2014) US Economic Prospects: Secular Stagnation, Hysteresis and the Zero
Lower Bound, Business Economics, Vol. 49 No.2, National Association for Business
Economics.
Wolf, M (2014) Radical cures for unusual economic ills, http://on.ft.com/1FoHqn1
Chart 1: Nominal gilt yields began a long period of decline in the 1970s
Per cent
Long-term UK gilt yields
18
16
14
12
10
8
6
4
2
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Source: Barclays Equity Gilt Study 2015, Bloomberg and Bank Calculations.
From 1899 to 1961 the gilt yield is annual observations based on the prices of undated British funds. From 1962 to 1991 it is
annual observations based on a portfolio of stocks chosen to represent as closely as possible a 20-year security. From 1992 to
present it is daily observations of the Bloomberg benchmark 20 year gilt.
Chart 2: Investment Grade corporate yields have also moved lower in recent years
Per cent
12
10
8
6
4
2
0
1997 2001 2005 2009 2013
Source: Merrill Lynch
Chart shows the nominal yield on the average UK corporate bond with a maturity of more than 18 months. The average
maturity is typically 10-12 years.
Chart 3: Market implied measures of long-term inflation expectations have been stable
Per cent
6
5
4
3
2
1
0
-1
1992 1995 1998 2001 2004 2007 2010 2013
20-year average (RPI) inflation rate implied by
comparing the yield on nominal and index-linked gilts
Headline CPI inflation
Source: ONS and Bank calculations
Chart 4: Unit wage cost growth has not returned to pre-crisis rates
Year on year
growth (%)
Unit wage costs
8
76543210-1
-2
1997 2001 2005 2009 2013
Source: ONS and Bank calculations. Unit wage cost defined as whole
economy AWE divided GDP per worker
Chart 5: Companies' investment intentions are above average
Differences from averages since 2000
(number of standard deviations)
3
CBI
2
1
0
-1
BCC
-2
-3
-4
2004 2006 2008 2010 2012 2014
Source: Bank of England, BCC, CBI, CBI/PwC
and Bank Calculations
Chart 6: Corporates are increasing the amount that they invest relative to the amount
that they save
£ millions
25000
20000
15000
10000
5000
0
-5000
-10000
-15000
-20000
1988 1993 1998 2003 2008 2013
Private Non Financial Corporates Financial
Balance
Source: ONS
Chart 7: The 10 year real rate beginning in 10 years is very low by historical standards
Per cent
6
5
4
3
2
1
0
-1
-2
1991 1995 1999 2003 2007 2011 2015
Source: Bank of England
Chart 8: The availability of credit to firms has improved
2011 2012 2013 2014 2015
Oct Dec Aug Dec Jun Sep Dec Mar Jun Sep Dec Mar
Small
Medium
Large
Overall
These cells indicate Bank's agents' national assessments of corporate credit availability. The greater the intensity of red, the
tighter credit availability; the greater the intensity of green, the looser credit availability. Yellow indicates normal conditions.
Includes bank and non-bank credit.
Chart 9: Term premia have been a significant driver of the decline in yields
Change in expected policy rates
Change in term premia
Basis
Change in nominal interest rates
0
-10
-20
-30
-40
-50
-60
-70
-80
-90
UK
Source: Bank calculations
Chart shows estimates of contribution to change in 10-year government bond yields between end July 2014 and end April
2015. Derived using the model described in Malik, S and Meldrum A (2014)
Chart 10: Central banks will purchase around $125bn per month (on average)until
September 2016.
Monthly flow of G4 Central Bank Asset Purchases
(6-month moving average, $bn)
250
200
150
100
50
0
2008 2009 2010 2011 2012 2013 2014 2015 2016
Euro Area Japan US UK Total
Sources: BoE, Federal Reserve, Bank of Japan, ECB, DataStream
Asset purchases have been converted to US$ using
$1.5 per pound, $1.15 per euro, and 120 yen per $.