The writer, Morgan Stanley Investment Management’s chief global strategist, is author of ‘The Ten Rules of Successful Nations’
One of the big mysteries in the global economy is why, though inflation is making a strong comeback, long-term interest rates have barely budged in recent months.
So far analysts have explained this odd market behaviour as a symptom of the pandemic, driven by fear of another surge in cases, or massive central bank asset purchases, or — above all — a belief that the current inflation spike is temporary.
None of these explanations hold up well in light of recent data, but there is an explanation that does: the world is in a debt trap.
Over the past four decades, total debt more than tripled to 350 per cent of global gross domestic product. As central banks dropped interest rates to their recent lows, easy money flowing into stocks, bonds and other assets helped boost the scale of global markets from the same size as global GDP to four times larger. Now the bond market may be sensing that the debt-soaked and asset-inflated global economy is so sensitive to rate increases that any significant rise is just not sustainable.
Surely, if all the standard explanations are falling apart then something deeper must be going on. Despite the rising Covid caseload, fear of its economic impact has given way to the assumption that vaccines and new cures will turn Covid into a normal part of life, like the flu. Global data show consumers are back out shopping and going to restaurants at near pre-pandemic levels.
At the crisis peak, the US Federal Reserve was buying 41 per cent of all new Treasury issues, but long-term yields stayed close to record lows even after the Fed and other central banks started signalling in early autumn their plans to wind down their purchases. Moreover, central banks are buying bonds of all durations, so why are rates now rising only for shorter-term bonds?
This is where the inflation scenarios come in — either that the current spike will pass as pandemic-induced supply shortages ease, or that the world is entering an era like the 1970s, with inflation becoming embedded in the system and people’s psyches.
Evidence is mounting that inflation is not as “transitory” as central banks have been insisting. Attention is focused on headline inflation, which hit a three-decade record of more than 6 per cent in the US last month. But core inflation measures — which exclude volatile prices such as food and energy, and serve as a better indicator of long-term trends — have spiked worldwide and are currently above 4 per cent in the US. Wages face long-term upward pressure as well: there are now more than six job openings for every unemployed American, a two-decade high.
Earlier this year, there was reason to hope that a rise in productivity might endure, restraining inflation in the long run, but it has faded. Surveys show people working from home are putting in longer hours to generate the same level of output.
Global bond markets are starting to price in expectations that higher inflation and growth will force central banks to raise short-term rates, starting next year. In fact, surging short-term rates are putting the world’s government bond markets on track for their worst year of returns since 1949.
Yet the yield on 10-year government bonds is now well below the rate of inflation in every developed country. The market is likely intuiting that, no matter what happens in the near term to inflation and growth, in the long term interest rates can’t move higher because the world is far too indebted.
As financial markets and total debts grow as a share of GDP, they become increasingly fragile. Asset prices and the cost of servicing the debt grow more sensitive to rate rises, and now represent a double threat to the global economy. In past tightening cycles, major central banks typically increased rates by about 400 to 700 basis points.
Now, much milder tightening could tip many countries into economic trouble. The number of countries in which total debt amounts to more than 300 per cent of GDP has risen over the past two decades from a half dozen to two dozen, including the US. An aggressive rate rise could also deflate elevated asset prices, which is usually deflationary for the economy as well. Those vulnerabilities would explain why the market appears so focused on the “policy error” scenario, in which central banks are forced to raise rates sharply, tripping the economy and eventually pushing rates back down.
In effect, the world is stuck in a debt trap, which suggests that while the refusal of long-term rates to rise significantly is new and unexpected, it may also be entirely rational.