A History of Interest Rates

Nominal yields on long-term government bonds have been constantly trending lower in the past 35 years, mainly driven by the lower global economic growth and the convenience yield for safety and liquidity. In addition, policy responses from both governments and central banks following the Great Financial Crisis have also contributed to the downtrend in LT interest rates globally, driving the term premium (investors’ compensation for holding interest rate risk) to negative levels.

Figure 1 represents the history of interest rates since the beginning of the 12th century up to today. The data source comes from Homer and Sylla’s book A History of Interest Rates (2005), which reviews interest rate trends in the major economies over four millennia of economic history. For the last 150 years, we compute a GDP-weighted average interest rate times series using a sample of 17 countries (Global LT interest Rate), using data from Jorda et al. paper The Rate of Return on Everything (2017).

One interesting observation was that in the past millennium, nominal interest rates have mainly traded below 10 percent, with two exceptions:

·         The first one is during the Spanish Netherlands period, which is the name for the Habsburg Netherlands ruled by the Spanish branch of the Habsburg. In the 16th century, Antwerp was one of the most important financial centres in the world, dominating international markets in sugar, spices and textiles. During a significant part of this century, the Exchange at Antwerp had dominated European transactions in bills of exchange and other credit instruments such as demand notes, deposit certificates and the bonds of states and towns (all short-term debts). Between 1508 and 1570 (when Antwerp defaulted on its debt), the interest rates were from loans by various bankers to the Spanish Netherlands government, Charles V and the city of Antwerp. We can notice that interest rates surged to 20% in the mid-1520s, and the bankers’ family, the Fuggers, made emergency loans to Charles V at annual rates as high as 24 to 52 per cent.

·         The second period of high interest rates was during the Great Inflation of the 1970s, which was marked by a sustained trend in inflation in the US that affected the rest of the World as well. A number of factors were associated to the rise in inflation during that decade: oil price shock following the 1973 embargo, speculation, avaricious union leaders and bad monetary policy management. As a consequence, long-term interest rates started to surge around the world, reaching a high of 14 per cent on average in 1981.

Interest rates globally are sitting at their lowest level in history, with the aggregate currently trading at around 0.5 per cent (probably trading between 1%-1.5% if we include some major EM economies to our times series of LT interest rates). As uncertainty has been constantly reaching new all-time highs (especially in the past year following the Covid19 shock) and growth expectations have been lowered accordingly, global yields have decreased dramatically since the last quarter of 2018 and broke below the lows reached in the late 16th century during the Republic of Genoa. At that time, Genoa became the banker for the Spanish Crown, a role previously held by German and Dutch bankers. The Bank of St. George was issuing placements or perpetual bonds called luoghi, which paid deferred dividends on the amount of taxes collected, after subtracting payment of the expenses of the bank.

The explanation of the persistence of very low real interest rates in advanced economies is a contentious issue. While many studies, including those by central bank research departments, stress secular forces such as demographics, over-indebtedness and dispersed income distributions – factors that emerged before the Great Financial Crisis – others find an important role for monetary policy in the determination of interest rates. On the secular view, a potential mean-reversion in long-term real interest rates must be driven by a global economic force such as a sustained period of above-trend economic growth. On the latter view, the monetary policy regime is endogenous to the real interest rate and the unconventional policies of the past decade are part of the explanation for low rates.

Figure 1. A History of Interest Rates

Source: Homer and Sylla, Jorda et al. (2017), Bloomberg, RR calculations

Great Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Time to go Long GBPAUD

For the past couple of weeks, GBPAUD has been recovering from its January losses as traders and investors are starting to price in a BoE rate hike in early 2015 (some observers target Q4 2014). Firstly, the UK unemployment rate fell sharply over the past few months since Carney introduced the forward guidance back in August 2013 and now stands at 7.2% (edged up 0.1% today in the quarter to December, but claimant count change down 27,600 In January vs. expectations of 20K), closed to the 7-percent threshold for considering a rate rise. Secondly, fundamentals remain pretty strong in the UK, with PMIs well above the 50-recession level (Mfg PMI printed at 56.7 in January) and the BoE raising its growth forecast (again) for 2014 from 2.8% to 3.4%.

Therefore, even if the annual inflation rate undershot the Bank of England’s 2-percent target for the first since 2009 (1.9% YoY in January), boosting the central bank’s case that there is no immediate need to raise the Official Bank rate, the British pound should continue to be supported against most of the currencies as the market is starting to believe in an early ‘BoE tightening’ scenario.

On the Aussie side, the $A dollar has recovered quite a bit since its low reached in late January (0.8660 on January 24 against the USD) supported by the demand for carry trades (AUDJPY is trading at 92.20, up four figures in two weeks) and driving other RISK-ON assets such as equities (S&P500 back to its December highs at 1,838). However, higher levels on the Aussie brought back traders’ interest to short the currency again as they consider that the recovery won’t last for long. Fundamentals remain weak in Australia as we saw last week with official employment data that showed a 3,700 fall in January versus a 15,000 rise expected by economists (Unemployment rate stands now at a 10-year high at 6.0%). Moreover, the Australian Bureau of Statistics reported overnight that the wage price index slowed to 2.6% YoY in Q4 last year (slowest annual increase since the series began in 1979), confirming RBA Governor Glenn Stevens’s commentary ‘the Aussie is uncomfortably high’.

Therefore, we maintain a bullish view on GBPAUD in the medium term; 1.8400 seems to be a good support to start buying on dips for a test back towards 1.8650 at first (1.8800 is our MT target).

(Source: Reuters)