23 July 2019

Who Is Right About the Bond Market?

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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 move together.

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 rise.

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.

Click here to access the full article on Bloomberg Businessweek.

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