The Forces Behind Negative Real Interest Rates

Of all the issues that economists have struggled to understand over the past few years, there's one that's particularly perplexing: While the fiscal health of the United States and Japan continues to deteriorate, evidenced by record fiscal deficits and debt-to-GDP ratios, both countries' bond yields have gone down and not up as common sense would seem to dictate. In the United States, in fact, the real rate of return on almost all federal government bonds is negative.

The standard explanation is that, since the economic downturn, the Federal Reserve has flooded the economy with cheap credit, and investors have preferred government bonds over equities and other corporate securities because the latter exposes their principal to risk of loss. The problem with this explanation, however, is that it's incomplete. Namely, the downward trend in government yields is by no means a recent phenomenon. As my colleague noted a few months ago, it's been ongoing for more than 30 years now.

The supply and demand of money
To understand why interest rates are so low, it's helpful to think of money as a commodity and interest rates as its price. Take corn as an example. On Friday, it was reported that the upcoming corn crop will be the largest in 75 years. What do you suppose will happen to its price? Assuming demand stays constant, of course, it'll go down.

Well, the same rules apply to money. Namely, its price is a function of supply and demand. On the one hand, an increase in the supply of money or a decrease in its demand will make money cheaper, and therefore drive interest rates down. And on the other, a decrease in the supply of money or an increase in its demand will make money dearer, and therefore drive interest rates up. For the economically inclined, this is the essence of monetary policy.

Supply and the "global savings glut"
At this point, if you'd guessed that the supply of money must have increased, you'd be exactly right -- though you may have misidentified the main culprit.

In 2005, the now-chairman of the Federal Reserve, Ben Bernanke, delivered a speech taking issue with the conventional view that the deterioration in the U.S. current account -- a measure of the trade deficit -- primarily reflects economic policies and other developments within the United States itself. The true cause, according to Bernanke, was what he called the "global savings glut." To be more specific, he argued that a combination of forces (namely, growth in the emerging markets such as China and an upward trend in oil prices) had created a significant increase in the global supply of savings in places such as Asia and the oil-producing countries.

While Bernanke's speech focused on trade imbalances, his savings glut hypothesis also explains why interest rates have detached from fiscal reality. Here's how. Since 2000, China's foreign currency reserves (a measure of savings at the sovereign level) have gone from $159 billion to $3.2 trillion, Saudi Arabia's have gone from $16 billion to $540 billion, and Russia's have gone from $9 billion to $462 billion. Meanwhile, over the same time period, China's demand for U.S. Treasuries has gone from $60 billion to more than $1.1 trillion. And when you take all of the oil-exporting nations together, their holdings of U.S. debt have gone from $48 billion to $259 billion.

Thus, to circle back around to the laws of supply and demand, there's been an enormous increase in the supply of money flooding into the United States. And as one would expect, thinking again in terms of interest rates, this has driven the price of money down.

Demand and the "missing market"
Now, if you've followed along this far, you may be wondering what's happened on the demand side of the equation, as an increase here would offset the downward pressure on interest rates. And it turns out the answer is: not much. The reason is what economist call a "missing market."

A missing market is a market failure that occurs when a competitive marketplace allowing for the exchange of a commodity -- be it a good, service, or whatever -- simply doesn't exist. Take pollution for instance. Prior to the introduction of environmental regulations, a factory that discharged pollution into the air or a nearby river typically wasn't responsible for all of the accompanying costs. That all changed, however, with the introduction of the cap-and-trade market, the system under which polluters can essentially exchange among themselves the right to pollute.

In the financial and monetary sphere, the problem lies in the undercapacity of credit markets -- for our purposes, think of government borrowing via bonds as the demand for money. Although new sources of money supply have come on line over the past few decades, no new sufficiently deep and liquid bond markets have come along as well -- thus, the missing market problem. Since World War II, the only two bond markets of note have been the United States and Japan. And while China is trying to get a complementary market up and going, called the Dim Sum market, it's still in its infancy -- a mere $29 billion in Dim Sum bonds were traded on the exchange last year, compared to America's $36 trillion market.

The future of interest rates
To summarize, one of the principal reasons real interest rates are so low, even negative in many instances, is because of a mismatch between supply and demand for money. The growing supply of funds from the emerging markets such as China and the oil-producing countries has simply overwhelmed the capacity of established bond markets. Consequently, if the above analysis is any indication, interest rates are bound to stay low for at least the foreseeable future -- that is, until other sources of demand like the Dim Sum market mature and/or come on line.

This is great news for companies such as Annaly Capital Management (NYSE: NLY  ) and Chimera Investments (NYSE: CIM  ) , both of which borrow money at cheap short-term interest rates and reinvest it at higher long-term rates, pocketing the difference. And it's also great for prospective homeowners, as the prime rate is lower than it's ever been. Whether this will result in a new lease on life for builders such as Hovnanian Enterprises (NYSE: HOV  ) or PulteGroup (NYSE: PHM  ) , the former of which is in the process of raising new capital, remains to be seen. But it at least gives them a fighting chance.

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Fool contributor John Maxfield does not have a financial position in any of the companies mentioned above. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (6) | Recommend This Article (12)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 05, 2012, at 4:15 PM, jonkai wrote:

    nicely written, and exceptionally informative.

    thanks, every once in awhile there are bloggers with nuggets to be had.

  • Report this Comment On April 05, 2012, at 9:11 PM, whereaminow wrote:

    Decent overview.

    ---> Prior to the introduction of environmental regulations, a factory that discharged pollution into the air or a nearby river typically wasn't responsible for all of the accompanying costs. <----

    That is completely untrue. The initial solution to pollution were cease and desist orders whenever private property holders were infringed by pollution. This happened quite often before the Progressive era. However, big business didn't like getting completely shut down. As a compromise, they joined forces with Progressives to sanctify a "legal" amount of pollution. Now the infringed property owner has no chance of protecting his land and air from polluters as long as they stay below the arbitrarily determined "proper amount" of pollution.

    I don't find that to be a superior solution. The free market was much harsher to polluters than Progressives.

    David in Liberty

  • Report this Comment On April 06, 2012, at 10:31 AM, randallwaechter wrote:

    There is another major factor (in my view) that is driving down interest rates that you have not touched on: Demographics. Japan, which has the highest debt-to-GDP ratio and one of the lowest interest rates on its government bonds also happens to have the oldest citizens (on average) of any country on earth.

    Is it possible that North America, driven by aging baby-boomers, is entering a long-term low interest rate environment where excess cash seeks low-risk, stable investments just like Japan?

    Here is my blog post on the topic: http://thesynapticgap.wordpress.com/

  • Report this Comment On April 07, 2012, at 2:23 PM, pedorrero wrote:

    Your analysis also misses a key point: "Money" as used in the modern world, is a completely imaginary "commodity", created out of thin air by central banks. It only has value because of public confidence. Some day that confidence will be gone, quickly or (if we're lucky) gradually. As applied to interest rates, these too are "broken." Far from indicating low demand for money, the current zero rates show that the FED is creating money and buying up almost all the government debt that is issued.

    The mentioning of pollution indicates a similar but broader problem: one of "social traps": like play money, a social trap is a type of system where the action that is rational for one person (or a group) will lead to a worse outcome (for the greater group) later. Those idealists who imagine a clean, brother-loves-brother future know nothing about the depressing lessons of history. We (mankind) may not destroy itself, but we have already made a pretty good attempt at the environment, and we will likely find our numbers vastly reduced in the distant future -- most likely by unpleasant means, both artificial and natural.

  • Report this Comment On April 08, 2012, at 12:34 AM, xetn wrote:

    Bernanke likes to deflect the real blame for sub-market interest rates to anyone but himself. In reality, it is his "QE*" that is the real culprit as "pedorrero" correctly identified. He has been creating trillions of new currency units out of thin air since 2008. Trillions of new currency units create a glut of new money, but much of it is being "locked up" by the banks as excess reserves at the Fed and earning a .25 percent return.

    On the other hand, the Fed is now the primary investor in treasuries, while China, once the largest holder has been quietly moving out of them.

  • Report this Comment On April 08, 2012, at 5:27 AM, knighttof3 wrote:

    <i> To summarize, one of the principal reasons real interest rates are so low, even negative in many instances, is because of a mismatch between supply and demand for money. The growing supply of funds from the emerging markets such as China and the oil-producing countries has simply overwhelmed the capacity of established bond markets. </i>

    Plausible, but wrong.

    The Fed has "bought" a majority of treasuries for the last year, creating currency out of thin air and supporting high bond prices and low yields.

    There is no inflationary pressure yet because wages are still low thanks to outsourcing and low hiring by risk-averse companies.

    The extra money sloshing around is getting pumped into assets, exactly like the pre-2007 housing collapse. First it was gold and treasuries, now it's stocks.

    Bernanke and Greenspan have locked us quite well into an ever increasing liquidity trap. The more the thing change, the more they remain the same.

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