Beyond GDP growth rates, of all the economic factors that make investors pause, some of the most concerning to me are the levels of interest rates around the world. The yield on 10-year U.S. Treasury bonds is currently below 2 percent, which is down from about 4 percent five years ago. Three-year Treasury notes are currently yielding less than 1 percent, while one-year Treasury bills are yielding about 0.25 percent. As I’ve cautioned many times in the past, investors seeking higher yields today are taking on considerable principal risks. Even small rate increases could result in substantial principal losses for longer-term bonds.
Less clear, but perhaps even more troubling, are the economic consequences of the sustained low-interest-rate environment that we’ve experienced. In all the time that interest rates have been recorded, there have rarely been periods in which rates have plunged to such low levels. And before you say that there isn’t much historical information for this sort of thing, it turns out that such information does exist going back almost 500 years!
Deutsche Bank, Global Financial Data Inc. and Bloomberg Finance LLP have compiled data detailing the yield on 10-year Dutch government bonds starting in 1517. From the mid-16th century on, the 10-year Dutch yield fluctuated mostly above 3 percent with periodic upward spikes. Only in the last several years has the yield dropped significantly below the 3 percent threshold. More than 100 years of information for Switzerland tells a similar, if slightly more extreme, story. In fact, the 10-year Swiss government bond yield has recently turned negative. Likewise, more than 140 years of data compiled by Robert Shiller and the U.S. Department of the Treasury shows the unprecedented nature of the sharp and prolonged decline in U.S. interest rates that has occurred during the past 30-plus years.
It’s fascinating to note that in all three countries, 10-year government bond yields peaked around the 1980s and have been trending sharply lower ever since, the result of the most-significant bull market in bonds ever. Though many observers, including myself, have largely attributed the recent low rates to the policies of the U.S. Federal Reserve and other leading central banks, there may be other factors in play as well.
So are we headed for another period of financial stress? That’s the question many investors are asking. While current stock valuations are elevated, I don’t see an obvious economic parallel to the situation leading up to the global financial crisis that began in 2007. For example, in 2007, it was strange that you could get a mortgage with no money down. It was also obviously problematic. It violated centuries of economic wisdom about the importance of “skin in the game.” Not surprisingly, no-money-down mortgages led to high rates of default.
Today, it’s strange that interest rates are at their lowest levels in almost 500 years. And the consequences are highly uncertain.
During the global financial crisis from 2007 to 2009, not only did the stock market suffer, but the entire economy was teetering. As a result, central bankers and policymakers appropriately came to the rescue. Today, in contrast, I feel that the global economy is on reasonably sound footing -- despite the slow growth around the world. But it’s important to note that investors can experience losses even when the economy is relatively resilient. For example, during the tech bear market from 2000 to 2002, stock prices generally fell despite the fact that quarterly GDP growth was positive in 10 out of 12 quarters.
My main point is that we’re in a “high-degree-of-difficulty” environment. There are no easy answers. Take oil, for example, which recently fell below $50 per barrel in a fast and furious decline. For those who think they know where oil is headed next, I’d ask how well they predicted oil’s price action in 2008 and 2009. Back then, oil had an even more dramatic decline -- only to recoup about two-thirds of its losses in relatively short order.
The same can be said about our ability to predict the consequences of the other phenomena I’ve discussed in this message: Low, even negative, interest rates throughout the world. New rounds of quantitative easing by the European Central Bank and the Bank of Japan. A rise in the value of the U.S. dollar that’s been more significant than at any time in the last decade. An intentional, prolonged depreciation of the Japanese yen. And slow economic growth contributing to fears of deflation. Can all of these occur without a major disruption down the road? Maybe. So I’m looking at these phenomena more with a sense of wonderment, rather than with any dire predictions. But it wouldn’t be surprising if the economy did indeed encounter some dragons in the coming years.
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