Falling bond yields around the world show that investors expect the malaise that has depressed investment and growth since the global financial crisis will continue through the year and beyond.
Investors in Australian government bonds last week were accepting an after-inflation return of just 0.15 per cent over 10 years, assuming the Reserve Bank hits its inflation target of 2.5 per cent.
This is still more than they would get in most other bond markets. An investor in US 10-year bonds at 1.99 per cent is accepting a zero real return.
With German 10-year bond yields dropping to only 0.43 per cent, success by the European Central Bank in keeping inflation at 2 per cent over the next decade would result in the confiscation of 17 per cent of investors’ savings over the decade. German five-year bond yields are negative.
The fact that bond yields are so depressed suggests that investors do not believe central banks will be able to hit their inflation targets. However, this underlines the central problem with the world economy. Demand is so weak that businesses feel they cannot lift prices and employees are not demanding wages.
Businesses believe they cannot make a risk-adjusted return from investing in capital expansion that is better than the negligible real return from government bonds.
There is an element of flight to safety in the bond markets. Asian investors selling out of Europe and buying into the US help to explain the entirely unpredicted rally in the US bond market over the past few weeks. The prospect of the US Federal Reserve raising rates this year led to forecasts that long bond yields would rise.
As well as the dismal European growth outlook, investors are also rattled by the prospect that the Greek election could deliver victory to leftist party Syriza and to Greece’s withdrawal from the eurozone. Although there have been suggestions in Germany that such a move could be handled without the disruption feared two years ago, many in the markets believe it would be another “Lehmann moment” for the world financial system.
While bond yields have fallen sharply in the past six weeks and have broken records, falling below the levels reached in the 1930s, the downward trend has been present for much longer. A year ago, US 10-year bonds were at 3 per cent, and there has been a fairly steady decline ever since, despite many signs of recovery in the US economy and the winding down of the US Federal Reserve’s bond purchases. Economists still expect the US Fed to be lifting rates by the middle of this year.
The US is delivering the best hope for the world economy, while the fall in the oil price will also help. The US cleared much of its overhang of debt and took some tough budget decisions in the wake of the financial crisis, and both consumption and investment are improving. The rising US dollar is improving the competitiveness of everyone else, including Australia.
Europe appears stuck in the same rut from which Japan has failed to escape since the early 1990s. Extraordinary monetary policy measures have resulted in banks sitting on vast amounts of cash that they would readily lend if they could find any takers. The demographics are bad, regulation is difficult and the public debt burden is large.
The European Central Bank is expected to embark on further extraordinary stimulus measures, buying government bonds to pump more cash into the financial system. Whether this does more than further distort asset markets remains to be seen. It is hard to see that deepening the trough of money will persuade the corporate horses to drink when they have been displaying no sign of thirst for the past six years.
In Australia, 10-year bond yields have fallen from 3.5 per cent over the past year to last week’s low of 2.65 per cent. This reflects global developments more than the local economic outlook. However, it is hard to see much nominal growth in the economy -- either rising profits or wages -- when the real return on government bonds is close to zero.
Short rates are a better indication of market expectations for the Australian economy -- they have been pointing to the difficult outlook resulting from further falls in export prices and the winding down of investment in the resources sector. Inflation is unlikely to lift, despite the fall in the Australian dollar raising the cost of imports. Businesses believe markets are so competitive that they cannot raise prices, while unit labour costs have not risen for two-and-a-half years.
A year ago, markets were optimistic about the outlook and anticipating 100 basis points of rate increases over the next 12 months. This had given way by September to a view that the RBA would be keeping rates on hold. Markets are now trading on the basis that there will be 50 basis points of rate cuts by the end of the year.
RBA deputy governor Philip Lowe says he does not believe monetary policy had yet run out of rope in Australia. “If further interest rate reductions were required they would have some effect in stimulating economic activity,” he said. But there would be few business capital investments ready to roll if only rates were 25 or 50 basis points lower. It would not release the pent-up animal spirits. A rate cut might result in reallocation of investment portfolios, with shifts from cash to shares or real estate, but it is unlikely to generate the sort of new asset investment needed to lift the economy out of its funk. As such, the case for a rate cut would not be strong, even if the economy shows further signs of stagnation.
Australia, through its chairmanship of the G20, and the International Monetary Fund, has emphasised the importance of infrastructure investment as a means of stimulating the economy. Spending on expanding the economy’s supply capacity would have a much more direct influence on aggregate demand than further rate cuts.
It has never been cheaper to borrow the funds needed.
However, governments have been unable to work out the governance to ensure that only worthwhile projects are supported, or how to do so in a way that does not jeopardise budget repair. The Abbott government has tried with its asset recycling fund, but not with the scale to make a meaningful difference to the broader economy.