How Come the Economy is Improving Yet Rates Have Gone Down?


US becoming like Switzerland where our economy gets better yet rates go lower. Declining rates may correlate with a declining recessionary economy. However if a country is the target of flight capital then even if the economy is booming, and thus is in a potentially inflationary environment and thus implies higher rates, if the world seeks to use the U.S. as a safe haven then the world will “overpay” for Treasuries. When I say “overpay” I mean that in the simplistic sense that Treasuries used to yield about a 2% real yield, so typically they yielded around 4 to 5% nominally. But that assumes we are in a bygone era when foreign investors had less influence over Treasury prices. If the rest of the world (EM, China, Japan, southern Europe and the Eurozone) are threatened with borderline recession then the global economy as whole is justified in pricing G7 sovereign debt to yield close to a zero real yield for a 10 year bond. German 10 year sovereign debt yields 1.3%.

One should review the history of banking where medieval goldsmiths started banking. In ancient times there was no safe place to store gold coins except to always have people at home guarding them. Then people started to deposit gold with goldsmiths because they had a safe and this led to banking. When someone deposited gold they had to pay a fee for safekeeping. This could be viewed as a form of negative yield or negative interest. You have to pay someone to guard the gold. Why should you be entitled to a real yield on a deposit if the depository company needs to pay employees to guard the gold?
So today’s banks and sovereign bond issuers are in a similar situation to the first gold depositories of ancient times where they act as a storehouse of wealth. One should not expect to be entitled to a yield in a medieval situation. Of course in modern times commercial banks lend money out so they can afford to pay depositors a yield. If banking spreads are 250 basis points over the wholesale Fed Funds rate and an “AA” corporate borrower can pay roughly the same as a Treasury then after subtracting a 250BP spread from a 250 BP yield on an AA corporate there is nothing left for bank to pay the depositor.

One should consider that they may be unduly afraid of a repeat of the great inflation of the 1970’s. That era was a peacetime outlier event. In 225 years of U.S. history that was the only peacetime inflation over the typical 0% to 2% inflation; the other eras of high inflation were during wars including the first two years after a war.

Investors need independent financial advice about contrarian anomalies like the bond market’s low yields during a growing economy. I wrote an article “Low global growth rate justifies low yields”.

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About the author

Don Martin, CFP®

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