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Why Are Long Term Interest Rates Low?

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The financial crisis and great recession almost a decade ago forced interest rates down to record lows. Over the past year, short term interest rates started to move higher while long term rates remain near historical lows. Why is this happening?

There are several factors causing long term interest rates to remain near historical lows, despite four fed funds rate increases totaling 100 basis points, or 1.00 percent. Low inflation, slower productivity growth, and a surplus of global savings have kept a lid on long term rates.



Investors have a gloomy economic outlook and anticipate low rates of inflation and output growth to persist for the foreseeable future. This outlook has also put downward pressure on long term rates.

Long term interest rates globally have traded down for almost three decades now. You can see in the chart below, 10 year government bond yields declined in the U.S, Germany, U.K, Canada, and Japan since 1990.



 

None of the factors mentioned above are expected to change much in the future. Yes, the Fed has announced they would begin implementing a balance sheet normalization program this year, but the Fed's actions still won't raise long term rates.

There has also been a change in the term premium on long term bonds because of accommodative monetary policy in the United States. The term premium is the premium investors expect when holding long term bonds instead of short term bonds.

Term premiums have been trending lower since the 1980s. The chart below shows the downtrend since 1981 and the accelerated downtrend the past couple years.



Investors are willing to earn less for holding longer term securities because there is a lower perceived risk in doing so. Expectations are for low inflation for many years in the future so there is less of a risk holding long term bonds. Term premiums on longer-term securities will move higher when investors perceived risk of holding those securities is higher. Don't count on this happening anytime soon.

Low inflation, low expectations of inflation in the future, and lower perceived risk in holding long term bonds isn't going to change in the coming years. That being said, low long term interest rates are here to stay for a long, long time.
 
Author: Brian McKay
September 8th, 2017