Writer, chief global strategist at Morgan Stanley Investment Management, author of ‘The Ten Rules of Successful Countries’
One of the great mysteries in the global economy is why, despite a strong return to inflation, long-term interest rates have barely budged in recent months.
Analysts have so far interpreted this strange market behavior as a symptom of the pandemic, fueled by fears of another increase in cases, or major asset purchases. of the central bank, or – above all – the belief that the current spike in inflation is temporary.
None of these explanations align with recent data, but there is one: the world is in a debt trap.
Over the past four decades, total debt has more than tripled to 350% of global gross domestic product. As central banks slashed interest rates to recent lows, easy money flowing into stocks, bonds and other assets helped boost the size of the global market from a size comparable to global GDP. up 4 times. Now, the bond market can sense that the global economy is awash in debt and asset inflation is so sensitive to interest rate hikes that any significant gains are unsustainable.
Surely, if all the standard explanations are collapsing, something deeper must be happening. Despite the rise of Covid, fear of its economic impact has given way to the assumption that vaccines and new cures will make Covid a normal part of life, just like flu. Global data shows that consumers are returning to shopping and going to restaurants at levels close to pre-pandemic.
At the height of the crisis, the US Federal Reserve bought 41% of all new Treasury issues, but long-term yields remained near record lows even after the Fed and central banks Another one started. heralds the beginning of autumn their plan to ease their purchases. Furthermore, central banks are buying bonds of all maturities, so why are interest rates now only rising on bonds of shorter maturities?
This is where inflation scenarios come in – either the current spike will pass as the pandemic-induced supply shortage eases, or the world is entering an era like the 1970s, with inflation already in full swing. deeply ingrained in people’s systems and psyche.
Evidence is growing that inflation is not “transient” as central banks have emphasized. Attention is focusing on headline inflation, which hit a three-decade record of more than 6% in the US last month. But core inflation measures – which exclude volatile prices like food and energy, and serve as a better indicator of long-term trends – have spiked worldwide and are now in over 4% in the US. Wages also face long-term upward pressure: there are now more than six job openings for every unemployed American, the highest level in two decades.
Earlier this year, there was reason to hope that the productivity increase might persist, curbing inflation in the long run, but it has faded. Surveys show that people who work from home are spending more hours producing 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 interest rates, starting next year. In fact, soaring short-term interest rates are putting world government bond markets on track for their worst year of profits since 1949.
However, yields on 10-year government bonds are now well below the rate of inflation in every developed country. The market is likely to assume that, no matter what happens in the short term for inflation and growth, in the long term interest rates cannot go higher because the world is so indebted.
As financial markets and total debt grow as a share of GDP, they become increasingly fragile. Asset prices and debt servicing costs are increasingly sensitive to rising interest rates, and are now a dual threat to the global economy. In previous tightening cycles, major central banks typically raised interest rates by around 400 to 700 basis points.
Now, much softer tightening could push many countries into economic trouble. The number of countries with total debt of more than 300% of GDP has increased over the past two decades from a half-dozen to two dozen, including the US. Aggressive interest rate hikes can also dampen soaring asset prices, which are often deflationary to the economy. Those gaps would explain why the market is so focused on a “policy error” scenario in which central banks are forced to raise interest rates sharply, hampering the economy and ultimately driving rates down. .
In fact, the world is stuck in a debt trap, which suggests that while it is new and unexpected to refuse to raise long-term interest rates significantly, it can also be entirely justified. .
