The Sustainability of the Low Long-Term Bond Yields

Allan Bødskov Andersen, Financial Markets, Jacob Wellendorph Ejsing, Market Operations and Michael Sand, Economics

INTRODUCTION AND CONCLUSION

In order to follow up on the description in Andersen, Hydeskov and Sand (2005) of the factors behind the low long-term US bond yields, this article reviews the sustainability of the low long-term yields. Since the previous article was published, long-term yields have risen, but viewed in a longer perspective the level is still low. In addition to the factors described in the earlier article, this article also discusses the significance of expanding income in the oil-exporting countries.

The assessment of the sustainability of the low long-term yield level addresses cyclical and structural factors separately. The former category includes investment and savings decisions, as well as time-varying risk premia. The latter category concerns purchases of long-term bonds by pension funds, Asian central banks and oil exporters. It is found to be highly probable that overall the cyclical factors will tend to push up long-term yields, in contrast to the structural factors, including recovered inflation stability, which have contributed to keeping yields at a low level.

CYCLICAL FACTORS

Long-term yields are influenced by a number of cyclical/temporary and structural/sustained factors. The cyclical factors include investments in real capital and part of the risk premium on purchase of long-term nominal claims.

Investments
According to Andersen, Hydeskov and Sand (2005), the global investment ratio is low in terms of global GDP growth, whereas global savings are at a more normal level. The relatively moderate propensity to invest is likely to have led to a decrease in real interest rates, and thus to equilibrium between realised global savings and investments.

New IMF (2006) data further underpins this argument. In recent years business enterprises in the G7 countries have accumulated an extraordinarily high net savings surplus, cf. Chart 1 (left-hand side). This was driven by non-financial corporations, whose net savings have traditionally been predominantly negative, cf. Chart 1 (right-hand side).

The savings surplus of the non-financial corporations can be explained by several factors. The IMF (2006) concludes that the surplus rose by 3 per cent as a ratio of GDP in the period 2000-04. Three quarters of this can be attributed to a fall in the nominal investment ratio due to such factors as adjustments after major investments in e.g. the telecom sector. This decline should also be viewed in the light of the long-term tendency for lower prices for capital goods – particularly IT – in relation to a broader price index. Thus, a smaller nominal investment is required to achieve a given level in real terms. As a result of the relative price drop, the rate of decrease in the investment ratio has been considerably stronger in nominal than in real terms. However, according to the IMF, the real investment ratio has nevertheless declined more strongly since 2000 than expected on the basis of the factors that are normally assumed to drive investments.

The last quarter of the increased savings surplus can be attributed to higher profits measured as earnings after tax and net interest. The generally higher profits of the non-financial corporations are primarily the result of lower taxes and interest expenses and to a lesser extent increased gross earnings. The growth in gross savings due to increasing profits is dampened by higher dividend payments.

Looking ahead, it is considered highly probable that the massive net savings in the non-financial corporations of the G7 countries will not be maintained. A continued favourable global cyclical position is deemed to entail growing capacity pressure and consequential increased business investments. At the same time, the propensity to save is expected to remain almost unchanged, so the outlook is for upward pressure on long-term yields, even though several factors point to limited investment growth. Thus, technological progress is expected to entail continuing lower relative prices for capital goods, which will dampen the increase in the nominal investment ratio. Other factors with a similar effect are the continued expansion of the less capital-intensive service sector and further tightening of monetary policy in the largest economies. The growth in interest expenses is, however, limited by the fact that the non-financial corporations have utilised the low level of interest rates to extend the duration of their debt, and that their indebtedness has been reduced at the same time.^[1]

Risk premia
Risk premia comprise both a structural and a cyclical component. Andersen, Hydeskov and Sand (2005) argued that the structural component of the risk premium for long-term nominal claims, such as 10-year bonds, has declined in recent years as a result of the reduced inflation risk. Thus, long-term inflation expectations are low and stable, and in recent years the volatility of actual inflation rates has been somewhat lower than in the high-inflation period in the 1970s and 1980s.

The low inflation and inflation-risk premium contribute to explaining the generally low level of interest rates and are found to be a more permanent factor, rooted in the high priority given to inflation control in economic policies. In addition, globalisation effects contribute to dampening inflation – directly via cheaper imported goods and indirectly via intensified international competition.

Furthermore, the lower inflation risk contributes to flatter yield curves on average since investors to a lesser degree than before seek compensation for inflation uncertainty when investing in nominal bonds with long maturities, e.g. 10 years.

Even though many factors point to a reduced risk premium in future, it will probably still vary over time. To illustrate a time-varying risk premium, Box 1 takes a closer look at credit spreads, i.e. the yield differential between a corporate bond with credit risk, i.e. the risk that the business enterprise defaults on its obligations, and a government bond without credit risk.

PROCYCLICAL RISK PREMIA	Box 1
The variation in risk premia over time can be clearly illustrated by considering the credit spread, i.e. the spread between a corporate bond subject to credit risk and a government bond not subject to credit risk. The credit spread expresses the expected loss on investment in a bond subject to credit risk, as well as the compensation for assuming the risk of loss. Chart 2 shows the credit spread for an index of corporate bonds for a given credit rating. This means that the bonds in the index can be assumed to be associated with a by and large constant risk of loss. Minor variations in the risk of loss can occur, however, even for a given rating, but surveys show that the fluctuations in the credit spreads are far too great to be explained by a change in the risk of loss (e.g. Berndt, Douglas, Duffie, Ferguson and Schranz, 2005). Most of the fluctuations in the credit spread instead reflect the variation in the price of risk, i.e. the compensation required by investors for purchasing bonds with a given credit risk varies over time. As Chart 2 shows, the price of risk is strongly influenced by cyclical factors. When the US GDP gap increases, corresponding to higher GDP growth than the potential growth, the credit spreads tend to narrow, and vice versa. This correlation was only really broken at the end of the 1990s and the beginning of the 2000s, but this is attributed to the debt crisis in Russia and the business scandals in the USA. The correlation reflects that investors are more willing to assume a risk during a boom, which is corroborated in a new in-depth study of credit spreads, cf. Amato and Luisi (2006).
CYCLICAL POSITION AND CREDIT SPREAD	Chart 2
Note: GDP gap is US GDP in relation to the trend (HP filter). Source: Moody's, EcoWin, NBER and own calculations.

The analysis in the Box concludes that the long-term yields will continue to be cyclically linked through a procyclical risk premium, but the cyclical effect will probably be reduced because the actual and expected inflation will vary less than previously. Viewed in isolation, the procyclical risk premium will contribute to lower long-term yields in a boom, while higher official interest rates – as a consequence of the central bank's reaction to the boom – will contribute to higher long-term yields.

The overall cyclical effect on the long-term yields is by no means clear, but the outlook for a continued favourable global cyclical position is found to probably entail slight upward pressure on long-term yields, due to a growing propensity to invest, in the next few years. 

STRUCTURAL FACTORS

Besides the cyclical factors, changed structural conditions also contribute to low long-term yields in overall terms. The most important structural change is found to be persistently lower inflation, resulting in lower risk premia, cf. above.

The following factors are also considered to be important:

• Demographic trends, i.e. a growing proportion of elderly people, combined with the transition to funded pension systems, as well as changes in supervision practices and new accounting standards for pension funds.
• The integration of China and the rest of Southeast Asia into world trade has contributed to lower inflation globally. The focus here is on China as the largest economy in the region (excluding Japan). The
  integration is supported by the Chinese fixed-exchange-rate policy that indirectly contributes to the low level of interest rates.
• Higher oil prices as a consequence of increasing global demand for energy. This means that the oil-producing countries have considerable income to recycle in the global capital markets.

Pension funds
The demographic effect of an increasing proportion of elderly people increases the savings incentive, while the greater use of funded pension systems is contributing to growing pension wealth in western countries in current years. The long duration of the pension funds' obligations gives them an incentive to invest in long-term bonds. This incentive is strengthened by changed supervision practices and new accounting standards.

The northern European countries, particularly the UK, the Netherlands and Denmark, and partly also the USA, have come a relatively long way in the implementation of appropriate supervision rules and accounting standards as well as in the accumulation of pension wealth, cf. Table 1. Assuming that it takes approximately one generation to build up the pension funds so that pension contributions roughly match pension disbursements, pension wealth will still be growing for a number of years. In addition, some countries, e.g. in southern Europe, still have relatively small pension funds. They can be expected to grow in the coming years.

In many cases, growing pension wealth will substitute other savings. For this reason the effect on total savings is less than the gross amounts. However, in all circumstances, the proportion of savings that is moved to pension funds, thus becoming subject to the supervision and accounting rules applying to such pension funds, will exert downward pressure on long-term yields in view of the pension funds' need to hedge long-term pension obligations by purchasing assets with long maturities, including long-term bonds. Pension savers outside the pension funds probably also contribute to the demand for long maturities because private individuals also have an interest in hedging their interest-rate risk. This effect is more uncertain, however, since hedging by private individuals is less systematic than hedging by pension funds.

China
As mentioned in Andersen, Hydeskov and Sand (2005), the strong accumulation of reserves in Asian central banks – particularly in China – contributes to the low long-term US yields, since the reserves are predominantly placed in US government bonds. There are several factors behind the accumulation of reserves, the most important being large current-account surpluses combined with a wish for a fixed exchange rate vis-à-vis the dollar to support continued export-driven growth and as insurance against currency crises after the Asian crisis in 1997-98. The fixed-exchange-rate policy is pursued with the help of intervention in the foreign-exchange market, i.e. by purchasing especially dollars against Chinese renminbi. In addition to the inflows of capital from the trade surplus, China in particular is recording very large inflows as a result of considerable foreign direct investments, as well as speculative inflows due to a widespread perception that the Chinese currency is undervalued.^[2]

China now has the largest foreign-exchange reserve in the world, cf. Chart 3. This raises the question of whether China's foreign-exchange reserve can grow indefinitely.

Intervention will usually increase the domestic money stock, which in the longer term can generate inflation. That is why the People's Bank of China absorbs some of the liquidity by selling certificates of deposit. The sterilised intervention technique is described in Box 2.^[3]

The direct costs of sterilised intervention are that the People's Bank of China pays the domestic Chinese interest rate for the certificates of deposit issued and receives the US interest rate on its dollar investments. Chinese interest rates are currently somewhat below US interest rates, among other things due to very large capital inflows, so holding a large foreign-exchange reserve is profitable for the People's Bank of China. China's current situation is thus somewhat different from the typical situation in e.g. many European countries in the 1980s when the interest rate in Germany was lower than in the countries pursuing a fixed-exchange-rate policy vis-à-vis the D-mark, e.g. Denmark.

Green (2005) estimates that the net profit on China's foreign-exchange reserve amounted to 11-18 billion dollars in 2004, and that only around half of the interventions in 2004 were sterilised. The reasons that China refrains from sterilising all interventions are that an expanding money stock contributes to supporting growth in China, and that China has vast unutilised labour resources, which reduces the risk of Chinese inflation rising out of control.

However, the growing holdings of dollar-denominated assets make China more vulnerable to fluctuations in the renminbi vis-à-vis the dollar and to changes in US interest rates that affect the market value of US bonds. In the event of a strong depreciation of the dollar and/or increase in US yields, the People's Bank of China will suffer a capital loss that, although considerable, is hardly likely to impact the overall Chinese economy.

There are no immediate indications that China's exchange-rate policy is under stress from a purely economic perspective. Inflation is under control and does not seem to be a threat, despite the high rate of economic growth. Furthermore, China's foreign-exchange reserve is directly earning interest in current years. In the longer term, however, the opportunities to sterilise interventions may determine how long China may intervene substantially without creating a risk of domestic inflation.

The pressure on China's fixed-exchange-rate policy is of a more political nature. The USA perceives China's trade surplus as a consequence of an underestimated renminbi. Consequently, the USA is constantly pressing China to reduce its trade surplus vis-à-vis the USA by revaluing the renminbi. In the summer of 2005, China adjusted the fixed-exchange-rate regime to allow gradual revaluation of the renminbi against the dollar. Since then, the renminbi has appreciated by approximately 3 per cent. Subject to the considerable uncertainty associated with such estimates, the market participants expect the currency to continue to appreciate at roughly the same pace. Furthermore, some observers believe that the People's Bank of China will diversify its exchange-rate risk to a higher degree by increasing investments in securities denominated in other currencies than the dollar, e.g. in euro. At the auctions of US government bonds, the proportion of the bonds that is purchased by Asian central banks already shows a declining trend.

Overall, the situation with growing foreign-exchange reserves, not least in China, is found to be sustainable in the sense that the probability of a sudden lapse of Chinese demand for US government bonds is perceived to be low.

Oil exporters
In step with the strong oil-price hike in recent years, the oil-exporting countries have accumulated considerable current-account surpluses, cf. Chart 4 (left-hand and right-hand sides). For example, in 2002 the total current-account surplus of the oil-exporting countries was on a par with that of Developing Asia, including China and India.^[4] The IMF (2006) expects the surplus of the oil countries in 2006 to be more than three times that of Developing Asia.

Since the propensity to save is higher in the oil-exporting than in the oil-importing countries, the growth in investments in financial assets by the oil-exporting countries exerts downward pressure on yields. The IMF estimates the total effect of the petrodollar recycling on the long-term US yields to be 30-35 basis points in 2005. However, this estimate is subject to considerable uncertainty.

The oil exporters' investments in foreign financial assets are of particular interest when assessing the effect on the global yield level. In principle, there is reason to assume that the OPEC countries in particular prefer dollar-denominated assets since most of these countries pursue a fixed-exchange-rate policy vis-à-vis the dollar.^[5]

With the exception of the Government Pension Fund in Norway, which has well-documented portfolios, data for the portfolios of the oil-exporting countries are few and far between.^[6] The official figures for OPEC's portfolio of US government bonds have increased considerably less than an immediate estimate would indicate, cf. Box 3. One possible reason is indirect purchase through financial institutions primarily in the UK, and that other assets than government bonds are purchased. According to the IMF (2006), one reason for this is stricter reporting requirements due to the US anti-terrorism act, among other factors.^[7]

WHAT HAPPENS TO THE PETRODOLLARS?	Box 3
Despite the scarcity of data concerning the extent of recycling of oil revenue in the international financial markets, a rough estimate can be made, based on certain assumptions, of the oil exporters' income available for investment in dollar-denominated assets. The IMF (2006) estimates that approximately 60 per cent of the reserves of the OPEC countries are held in dollar-denominated assets and that this proportion has not changed significantly in recent years. Furthermore, assuming that the oil price will remain at the current level of around 70 dollars per barrel for the next two years, and that the countries save up 50 per cent of the additional income from exporting oil, it is possible to estimate the future scope for petrodollar recycling of the oil countries.1 The calculation assumes that OPEC's exports will remain at the current level of around 22 million barrels per day, or almost 8 billion barrels per year. Chart 5 (left-hand side) shows that subject to these assumptions the OPEC countries will accumulate dollar-denominated assets in the range of 95 billion dollars per year, or more than 40 per cent of the estimated annual growth in China's total foreign-exchange reserve in the last 2 years.2 Furthermore, revenue from gas sales is not included in the calculations, nor is further accumulation in primarily Russia and Norway. The OPEC countries' official holdings of US government bonds increased by only just over 50 billion dollars from January 2004 to February 2006, cf. Chart 5 (right-hand side), while the scope for petrodollar recycling is estimated to have increased by around 85 billion dollars in the same period. Besides indirect purchases of securities via e.g. the UK and incomplete assumptions, the difference between the estimate and the actual figure can be explained by direct investments, bank deposits or purchases of US corporate bonds and equities.3
OPEC'S ACCUMULATED SCOPE FOR PETRODOLLAR RECYCLING AND HOLDINGS OF US GOVERNMENT BONDS	Chart 5
Note: The oil price applied is a simple average of the prices of the oil types WTI, Brent and Dubai Fateh. The figures include OPEC. Source: Bloomberg, OPEC (2004) and US Treasury International Capital System and own calculations.
1  This corresponds to market expectations, cf. the article on p. 49ff. 2  The figure is 7.88 billion barrels per year * (70-30) dollars per barrel * 0.6 * 0.5 » 95 billion dollars per year, where 30 dollars per barrel is the price level before the oil-price increase. 3  The UK's official portfolios of US government bonds increased by almost kr. 160 billion from January 2004 to February 2006. In this period, Norway saw an increase of kr. 38 billion.

A persistently high oil price combined with the oil countries' continued fixed-exchange-rate policies against the dollar indicates considerable continued portfolio investments in dollar-denominated financial assets. On the other hand, an investment lag in the oil-exporting countries and a young population, particularly in the Middle East, compared to the OECD countries, imply pressure for massive (public) local real investments, cf. Cordesman (2005). However, the overall assessment is that the petrodollar recycling will continue to be substantial, since the oil-price increase is to a high degree driven by permanent factors, cf. the article on p. 49ff., so that the interest-rate effect is expected to persist.

All of the structural and thus long-lasting changes in the global economy that have characterised the development in recent years essentially contribute to the low level of interest rates. Recovered inflation stability, combined with strong demand for long-term claims from pension funds, central banks and oil-producing countries alike, make it probable that the long-term yields will remain at a low level. Naturally, this does not mean that yields will be completely stable, and especially the long-term yields might continue the rising trend observed in the last six months, driven by the cyclical development, cf. above. However, substantial interest-rate increases, as a return to the levels of the 1970s and 1980s, are regarded as unlikely. The reason is that globalisation contributes to keeping inflation in check, and that such a high-interest-rate scenario would require the credibility of key central banks to be reduced, followed by a period of uncontrolled inflation.

LITERATURE

Abildgren, Kim (2005), Sterilised and Non-Sterilised Intervention in the Foreign-Exchange Market, Danmarks Nationalbank, Monetary Review, 1st Quarter.

Amato, Jeffery D., and Maurizio Luisi (2006), Macro Factors in the Term Structure of Credit Spreads, BIS Working Paper, No. 203.

Andersen, A., Hydeskov, J. and M. Sand (2005), Why Are Long-Term US Yields Low?, Danmarks Nationalbank, Monetary Review, 4th Quarter.

Berndt, A., Douglas, R., Duffie, D., Ferguson, M. and D. Schranz (2005), Measuring Default Risk Premia from Default Swap Rates and EDFs, Working Paper, Stanford University.

Cordesman, A. H. (2005), Saudi Economics and Saudi Stability, Research report, August, Center for Strategic and International Studies, Washington DC.

Ejsing, J., Hydeskov, J. and P. Mindested (2006), Why Have Oil Prices Risen?, Danmarks Nationalbank, Monetary Review, 2nd Quarter.

Green, S. (2005), Making Monetary Policy Work in China: A Report from the Money Market Front Line, Stanford Center for International
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IMF (2006), World Economic Outlook, April.

OECD (2005), Pension Markets in Focus, Issue 1, June.

OPEC (2004), Annual Statistical Bulletin.

Roubini, N. and. Setser (2005), Will the Bretton Woods 2 Regime
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