Are Low Interest Rates a Sign of Secular Stagnation?

3rd April 2015

Despite six years of "zero rates", global growth remains tepid. At the latest count, 21 central banks have cut policy interest rates in 2015 and long-dated yields have fallen to unprecedented levels in the eurozone. At the time of writing the German yield curve is negative in bonds up to seven years in maturity and JP Morgan estimates that $1.9 trillion (30%) of the euro area bond market now has a negative yield. The eurozone has been the principal driver of the drop in G7 bond yields which are now below G7 core inflation for the first time in 20 years.

If negative yields are the smoke, is secular stagnation the fire?

There is a concern that the latest fall in interest rates is just another chapter in a long-running saga of declining yields and that the underlying trend is being driven by secular stagnation. This occurs when an economy suffers from a chronic deficiency of demand such that it requires lower and lower interest rates to stimulate activity. Are the concerns justified?

The theory fits many of the facts, as global growth has been disappointingly weak despite the fall in interest rates to record lows. Six years on from the financial crisis' start, the Fed, Bank of England, ECB and BoJ all have interest rates at - or close to - zero. If secular stagnation is the root cause, central banks may have to continue, or even restart quantitative easing. In which case; yields will trend even lower.

Balance sheet repair takes time

Our view is that the secular stagnation hypothesis is overly pessimistic. There is evidence to support it; such as a slow down in business investment in major economies such as the US, Germany and Japan. However, we see the world economy in a period of balance sheet adjustment; with countries emerging at different rates from the banking crisis. The US and UK recapitalised their banks at an early stage of the financial crisis, but the eurozone has taken much longer. However, even here we are seeing signs of a return to lending following last year's Asset Quality Review and stress tests. The danger is that the eurozone upswing has come too late to prevent a slide into deflation or that the legacy of the crisis means that banks and households have become reluctant to re-leverage. More broadly there are also concerns that China is the next shoe to drop in terms of the need to recapitalise its banking system.

Forecast update: pushing out Fed rate rise

Following the mid-March meeting of the Federal Open Market Committee, we have pushed out our forecast for the first rate rise until September 2015. Although the committee changed its language and opened the door to a June move, it also cut its forecasts for growth, inflation and interest rates. The main factor which has swung our view towards a later move has been the strength of the US dollar which will weigh on inflation in the US.

Issued by Schroders - www.schroders.com/