When the Australian Office of Financial Management borrowed A$4.25 billion for 20 years at an interest rate of just 2.865% this week, economic commentator Peter Martin called it “the deal of the century”.
Governments issue bonds to raise funds to pay for general expenses and projects such as the development of infrastructure. Investors buy government bonds from the governments that issue them. In return, as bondholders, they typically receive periodic interest payments (known as the coupon), in addition to repayment of the principal when the bond matures.
Prior to the global financial crisis, yields on long-term Commonwealth government bonds averaged around 5.5%. Since then, yields on 10-year bonds have fallen to record lows of 2.5% (see chart below). These falls are, of course, not unique to Australia and can be observed across Western economies generally as investors have flocked to safe-haven assets.
Current prices indicate investors are prepared to accept very little return for holding government debt. In the long run, investors require yield to compensate for both risk and erosion in the buying power of money. At current yields, however, it is not clear that they are being compensated for either. This is an issue raised recently in a speech by Assistant Reserve Bank Governor Guy Debelle.
10-year Commonwealth Government Bond Yields
As yields on long-term government bonds have fallen, the spread between long- and short-term bond yields has also fallen (see chart below). The current spread is close to zero, notwithstanding the Reserve Bank’s target rate being at a record low. Ostensibly, this suggests that investors do not expect any substantive economic recovery in the next ten years. The economic rationale for this expectation is unclear.
Spread between 10-year and three-month Commonwealth Government Bond Yields
What determines the term spread?
The spread between the long and short rates reflects the term structure of interest rates. The term structure, which can be decomposed into its short and long-term components, is particularly important as it provides information on the borrowing rates of firms and households in the short, medium and long term. The short-end, which reflects borrowing costs in the next few months, is heavily influenced by monetary policy.
The long rate, reflecting longer-term borrowing costs, is typically more difficult to rationalise. Research suggests that factors such as debt-to-GDP levels, potential economic growth, overseas interest rates and exchange rates are significant determinants of long-term real interest rates.
Since the falling long rate is a general phenomenon among advanced economies, we can probably abstract from issues such as overseas rates and exchange rates and focus on factors relevant to a closed economy such as the debt-to-GDP ratio and economic growth. Research suggests that the latter driver is the more important of the two.
What is driving current long-term yields?
Given that government debt levels have not fallen (rather, the converse has taken place), it is fairly clear that investors are attaching relatively little weight to the level of government indebtedness in the current economic climate. As debt levels have risen in the US, for example, US bond yields have continued to decline. It would appear, therefore, that investors are accepting lower bond yields on the basis of low economic growth expectations – not only in Australia, but across the advanced economies.
This seems, however, to explain only part of the story. Economic growth and inflationary expectations do not appear to be sufficiently low to warrant current nominal long-term rates. At current levels, real yields are close to zero, implying inordinately low levels of real economic growth in the long run.
It appears sensible to conclude that uncertainty regarding economic growth and policy, rather than expectations of low inflationary conditions or economic growth, is largely responsible for the record low long-term government bond yields in Australia.
This argument is supported by research suggesting that – during periods of uncertainty – investors engage in a “flight to liquidity” involving the purchase of liquid, low-risk assets such as government bonds. This uncertainty is almost certainly related to the ramifications of both the GFC and the European debt crisis, resulting in the doubling of foreign holdings of Commonwealth government debt (as a proportion of GDP) since the GFC.
Policy uncertainty regarding the stability of the European Union (and its membership), the nature of the G20’s financial stability measures and their ramifications for the capital structure of the banking sector, and economic uncertainty regarding the robustness of the US recovery have resulted in investors sacrificing yields for safety and liquidity. Although flights to liquidity and quality are probably temporary, they may endure for years before subsiding.
The risks and benefits for government
Low bond yields allow governments to raise inexpensive funds that can be used to fund infrastructure investment. They also reduce fiscal pressure by reducing interest costs.
Unreasonably low yields, however, are also reflective of less positive characteristics of the economy. In particular, an unwillingness to lend to the private sector and/or reluctance by the private sector to borrow for investment reduces the capacity for private sector growth, which has obvious negative ramifications for employment conditions. Consequently, in an environment of inordinately low long-term interest rates, there is a significant onus on both the fiscal and monetary arms of the economy to support clear policies designed to promote growth and employment.