Real interest rates on ‘safe’ assets such as high-quality government bonds had been stationary around 2% for more than a century until the 1980s. Since then they have witnessed an unprecedented global decline, with most developed markets converging on the U.S. market trend. There is evidence that this trend decline and convergence of real rates has been due prominently to rising convenience yields of safe assets, i.e. greater willingness to pay up for safety and liquidity. This finding resonates with the historic surge in official foreign exchange reserves, the rising demand for high-quality liquid assets for securitized transactions and the preferential treatment of government bonds in capital and liquidity regulation (view previous post here).
The post ties in with SRSV’s summary lecture on on public finances, particularly the section on financial repression, as well as the lecture the regulated banking system, particularly the section on regulatory reform.
The below are quotes from the paper. Emphasis and cursive text have been added.
“We study the joint dynamics of short- and long-term interest rates, inflation, and consumption for seven now-advanced economies since 1870. We do so through a flexible time-series model, a vector autoregression (VAR) with common trends… we use one lag in the VAR, both because we use annual data and for computational feasibility… The system is estimated jointly for all seven countries in the sample.”
“The interest rates in our data set are on either government securities or close substitutes, which are relatively safe and liquid compared to other privately issued assets… convenience yield for safety and liquidity offered by these ‘safe’ assets to play a role in driving the international cross section of returns.”
The long-term real rates trend
“Our estimates indicate that…the trend in the world real interest rate fluctuated in a fairly narrow range around 1.5% through the post-World War II period, reaching a peak close to 2% just before the Great Depression and a trough a bit above 1% in the early 1950s. From then it rose steadily through the early 1980s, when it touched 2.5%….But it has been declining ever since, dipping to about 0.5 percent [by the 2010s]… the drop over the last few decades is precisely estimated. A decline of this magnitude is unprecedented in our sample. It did not even occur during the Great Depression in the 1930s.”
“The trend in the world interest rate since the late 1970s essentially coincides with that of the U.S. In other words, the U.S. trend is the global trend over the past four decades. In fact, this has been increasingly the case for almost all other countries in our sample: idiosyncratic trends have been vanishing since the late 1970s. This convergence in cross-country interest rates is arguably the result of growing integration in international asset markets.”
“The persistent co-movement of real rates over the past four decades is evident to the naked eye. Ultimately, this low-frequency co-movement is what drives the estimated decline in the trend… Country-specific components [of real rates] have shrunk noticeably since the late 1970s, bringing the trends much closer together and also to the world real interest rate.”
“Convergence [of inflation has been] less pronounced and uniform over time than for real returns.”
The convenience yield effect
“A key component that we consider is the convenience yield that distinguishes widely traded government bonds from comparable assets that are less liquid and safe…Convenience yields…reflect the money-like convenience services offered by assets with special safety and liquidity characteristics…such as U.S. Treasury bonds. In equilibrium, the willingness of investors to pay for these services gives rise to a wedge between the return on safe assets on the one hand and that on securities with the same pecuniary payoffs, but no such special attributes, on the other.”
On the importance of convenience yields for the level of risk free interest rates view post here.
“The trend decline in the world real interest rate over the last few decades is driven to a significant extent by an increase in convenience yields, which points to a growing imbalance between the global demand for safety and liquidity and its supply. This contribution is especially concentrated in the period since the mid-1990s, supporting the view that the Asian financial crisis of 1997 and the Russian default in 1998, with the ensuing collapse of LTCM, were key turning points in the emergence of global imbalances.”
“In the international context, the presence of convenience yield differentials between assets denominated in different currencies, and/or originating in different economies…gives rise to deviations from the usual interest rate parity conditions.”
The consumption (savings) effect
“A global decline in the growth rate of per-capita consumption, possibly linked to demographic shifts, is a further notable factor pushing global real rates lower. Its contribution is comparable in magnitude to that of the convenience yield since 1980, but only about half as important over the last twenty years (and less precisely estimated).”
“A connection between the stochastic discount factor and some function of consumption growth forms the basis of most macro-finance asset-pricing theories, even if the empirical relevance of the resulting relationship between economic growth and rates of return has often been questioned.”
“There is not much left to explain in the secular decline in the world safe return once the convenience yield and consumption growth are accounted for.”