Academic and policy economists are taught to leave market
predictions to the well-paid folks in the financial industry. But lately, not
only are they coming out with bold predictions, their expectations are the
complete opposite of what industry expects. Financial industry experts say
interest rates will rise, the only question is when. Meanwhile, several
prominent economists have released an e-book arguing rates will stay
low for the foreseeable future, perhaps for decades.
In the e-book, International Monetary Fund Chief Economist
Olivier Blanchard, Davide Furceri, and Andrea Pescatori argue demand for safe
assets will stay strong: Emerging-market governments, the aging population, and
financial firms all need high-quality bonds. The economists also anticipate
muted investment demand—all of which will keep rates low.
To make sense of the disconnect, it helps to remember that
academic economists and finance professionals face different risks from the
bond market. The economists mostly worry that if rates stay low it will be
harder to conduct monetary policy. Financial professionals think more about
investment risk and what it will do to their, and their clients’, portfolios.
In addition to having different stakes, they also may be
talking about different bonds. When forecasting low rates, many of the
academics often use interest rates as a generic term to mean all government
bonds and seem to mean bonds of all different maturities. Finance industry research argues
that very short-term rates might stay low, but longer-term rates (10-year
bonds) are due to rise, and it expects the yield curve to steepen.
The difference is notable because in financial markets how
short- and long-term bonds move in relation to each other is just as important
as interest rate levels. Large investors, like pension funds, often hedge their
liabilities using methods that don’t work well when short and long rates don’t
The economists don’t offer much explanation as to why both
long- and short-term bond yields will stay low. But they are not substitutes
for each other; long-term bonds are much riskier. Their price is determined by
short-term interest rates and a premium that compensates investors
for that risk. The price of a 10-year U.S. Treasury bond accounts for inflation
risk and future debt worries, among other risks.
If the risk, demand, or regulatory environment changes, the
market for short- and long-term bonds could start to look very different.
Historically, defined-benefit pensions have been big buyers of long-term debt.
In the last 30 years, many private employers replaced pensions with 401(k)s and
other defined-contribution plans. Defined-contribution investors face different
risks; they typically hold shorter-term bonds. As defined-benefit plans age
out, demand for long-term debt might fall and long-term interest rates could
Nonetheless, the shape of the current yield curve suggests
the academics are right—for now. Despite all the rising rate speculation
from the finance industry, the market still expects long-term interest rates to
stay low, too. But the risk premium can be unpredictable. If it changes
quickly, interest rates may very well rise.
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