Long-term interest rates have increased in recent months as investors have become more concerned about inflation’s persistence and the ability of the G-7 economies to support higher government debt.
Interest rates can be thought of as a measure of an economy’s ability to support investment. The risk premia added to a central bank’s policy rate account for the uncertainty of inflation and the ability of the economy to support unfunded government spending.
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Because of these uncertainties, investors are requiring higher interest rates to buy long-term debt.
Recent calls for lower interest rates in this period of higher inflation and unfunded government spending are antithetical to market-based determination of financial asset prices.
Inflation and long-term yields
In the decades after the oil embargoes and inflation shocks of the 1970s and 1980s, the development of a coordinated monetary policy across nations and global supply chains that lowered prices helped squash inflation.
By the mid-1990s, inflation was at reasonable levels, which became the prelude to China’s flooding the global market with inexpensive consumer goods.
The confidence in the ability of central banks to avoid high levels of inflation led to a secular decrease in long-term interest rates from 1985 until 2020.
But now, the inflation unleashed by the pandemic and its persistence have created the basis for higher interest rates.
Government debt and long-term yields
From the 1970s until the financial crisis, government debt remained less than 5% of nominal GDP, a sustainable level of debt necessary to invest in the growth of the economy and the health of the workforce.
The depression-level distress of the financial crisis required a fiscal boost in 2010 and the debt level increased to 10% of GDP. The debt fell back to less than 5% of GDP by 2015 before rising again going into the 2020 pandemic.
When short-term interest rates were once more pushed to near zero by the Fed, the bond market pushed long-term rates close to 1%.
In the current period, the debt-to-GDP ratio has exceeded 5%, with the bond market well aware of unfunded government spending and further threats to tax revenue should economic growth stall out.
The takeaway
Because long-term Treasury bonds carry the uncertainty of inflation and the ability of the economy to support unfunded government spending over the life of the bond, investors require compensation for that risk.
Given the deviation of inflation from central bank targets—the Fed’s forecast implies seven consecutive years of inflation above its 2% target— investors are demanding higher risk premia to finance government spending.
As the Fed cuts rates into rising inflation, the risk of persistent increases that lead to a wider deviation from target is growing more probable.
