Han Dieperink: Back to the old normal
This column was originally written in Dutch. This is an English translation.
Low interest rates were not the ‘new normal’, but an exception. Now that the global savings surplus is disappearing, we are returning to structurally higher interest rates and full-fledged bonds.
By Han Dieperink, written in a personal capacity
Over the past fifteen years, it seemed as though low interest rates had become the new normal. Following the 2008 financial crisis, government bond yields fell to historic lows. Central banks kept policy rates around zero for years, bought up bonds on a massive scale, and the ten-year US yield often hovered below 2 per cent. Investors became accustomed to money being almost free and to bonds serving primarily to reduce risk, rather than to generate returns. That period was fuelled by a global savings surplus: governments were cutting spending, US households were paying off debts, and China was exporting vast amounts of savings to the West. This pushed real interest rates down structurally.
Since the pandemic, interest rates have risen sharply and we appear to be returning to the ‘old normal’, to pre-2008 levels. The driving forces behind the savings surplus have largely disappeared. Governments in the United States and Europe are pursuing pro-cyclical fiscal policies with persistently high deficits. US consumers are once again spending freely and businesses are investing heavily, particularly in technology and artificial intelligence. China continues to export savings, but is encountering trade barriers and is increasingly focusing on emerging markets. As a result, the real interest rate – the portion of the interest rate that excludes inflation – has risen significantly in recent years. There is now sufficient demand to match the supply.
The neutral or natural interest rate – the rate that keeps the economy in balance without fuelling or dampening inflation – is currently higher than it was during the ‘new normal’. This is also evident from the fact that, taken together, all the interest rate rises ultimately failed to trigger a recession. Combined with well-anchored inflation expectations of around 2.25 per cent and a term premium moving back towards 1 per cent, this results in a real yield for the ten-year US government bond of between 4 per cent and 5 per cent. The current yield of around 4.7 per cent falls within this range. The market has already largely priced in the end of the savings surplus.
For investors, this return to higher interest rates has significant implications. It is wise to stop speculating on another sharp fall in interest rates. A strategy of returning to the higher level of the neutral interest rate works better. When interest rates move towards 5 per cent, that is the time to extend the portfolio’s duration. Conversely, it is wise to reduce duration if interest rates fall too far below 4 per cent. US bonds are also offering a decent return again, something that was hardly possible in the previous decade. Higher interest rates are positive for equities, as the cause of these higher rates lies in stronger economic growth. According to the classical Fed model – whereby the return on equities should be roughly equal to the bond yield – a price-to-earnings ratio of 20 to 25 is justified. The current forward price-to-earnings ratio of the S&P 500, at around 21.5, fits neatly into this.
The period of low interest rates that we called the ‘new normal’ was, in reality, an exception, driven by temporary savings surpluses. We are returning to an environment in which interest rates are structurally higher and in which bonds are once again a fully-fledged asset class.