COVID-19 Recession starting point – Zero interest rates, flat yield curves and high debt

This note dusts off a few long-term charts to provide some background for debate about the economic and market outlook and the implications of the COVID-19 recession for Asset Allocation and Portfolio Construction.

The COVID-19 recession is increasingly looking like the tipping point for a sustained regime shift in policy, with potentially major implications for economies and markets. It’s not just the arrival of the pandemic and its immediate impact on people and economies – it’s the starting point for the COVID–19 recession that matters. Historically high debt levels, historically low interest rates, disinflation pressures, already flat yield curves and elevated asset valuations present an extremely challenging backdrop as policy makers respond to the onset of a deep global recession. Already the scale of the global policy response is unprecedented while the co-ordination of monetary and fiscal support in many economies is a step change in approach that looks likely to have longer term implications for the economic and market outlooks.

Let’s talk about debt

Global government debt levels were high and rising in both developed and emerging economies pre-COVID (left chart). Pre 1970s, large fiscal deficits were confined to war times – that has changed – fiscal deficits have become more structural in many developed economies including the US (right chart).

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Even before COVID-19 developed world government debt was already forecast to expand massively over coming decades as populations age (US and UK chart below).

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It’s not just government debt levels that are historically high as corporate and household debt levels are also elevated relative to history across regions. Overall, global debt to GDP has continued to grow over the post-GFC period and this year’s addition to that debt load will be the largest outside of WW2. The chart below projects 2020 government, corporate and household debt to GDP increases flowing from the COVID-19 recession response across regions.

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High and rising government debt levels have the potential to limit fiscal policy options going forward, although some of those governments with very high debt levels may not face near term constraints where that debt is domestically held or where national central banks offer a ready source of demand.

The problem with interest rates

When COVID-19 arrived the world already had the lowest short term and long-term nominal interest rates in over 100 years. (Left Chart below)

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Long term and short-term nominal interest rates have been falling since the early 1980s. The world transitioned to an even lower ‘new normal’ policy rate regime following the GFC, though it took many market participants a long time to fully accept that reality. For much of the past decade forward markets had priced a normalisation in policy rates towards pre-GFC norms that never materialised. The fact that the ECB couldn’t lift short term interest rates from below zero even when real growth hit 3% in 2017 and then the Fed being forced to pivot in early 2019 finally convinced most investors that historically low rates would be with us for much longer than previously understood.

Real interest rates have fallen since the early 1980s as well. Real long-term bond yields have been lower than current levels over the past century (Right chart above), but only in periods of relatively higher inflation (something central banks are desperate to engineer). The rolling 10year average US real bond yield (left chart – red line) shows that sustained shifts in the prevailing real interest rate regime have always been a feature of markets. We should remain open the evidence that regimes can and do change in ways that matter for economies, markets and portfolios.

With interest rates where they are, yield curves flat and risk asset valuations not cheap it will be very hard for central banks to stimulate economies directly via lower policy rates or even indirectly via asset purchases.

A new policy regime?

There is a very real prospect that the COVID–19 recession will mark the arrival of a new policy regime: due not only to the depth of global economic downturn but also due to the preconditions touched on above which will shape the policy response.

  • With monetary policy less able to stimulate growth fiscal expansion is essential – and increasing evidence that COVID will be impacting growth for some time yet only raises the likelihood that fiscal expansion will need to be sustained.
  • Given already elevated government debt levels – increasing issuance will potentially require more buying from central banks to contain bond yields. Rising bond yields could be particularly damaging to a high debt slow growth world.

Effectively a monetisation of government debt (fiscal spending financed by central bank purchases of government securities) is already in happening in several regions as fiscal deficits increase while at the same time central bank balance sheets expand as they increase purchases of government debt. This policy mix may not be wound back anytime soon without a miraculous shift in the path of the pandemic and a sustained global economic recovery.

It is worth contemplating that a modest pickup in inflation while interest rates remain anchored would effectively reduce real yields which, considered in isolation, could be a support to some asset pricing. It’s not that simple of course, a stagflation scenario where the modest pickup in inflation is accompanied by expectations of more sustained period of weak global growth might present a less benign backdrop for asset prices.

The aim of this short piece is not to present a view about the policy, interest rate and economic outlooks but rather to raise awareness of some major uncertainties ahead. Economic, policy and market regimes can and do change and the starting point for the COVID-19 recession raises the potential for a sustained shift in policy which has potential major implications for economies and markets over the upcoming medium term and beyond.

JANA’s portfolio construction research agenda is currently focused on related topics which include a re-examining of the role and design of defensive allocations in a world of near zero bond yields and a broader review of portfolio resilience to an unusually uncertain outlook.

A new policy regime which includes a stronger fiscal response alongside extreme monetary support has implications for the intermediate term outlook for global growth, inflation, interest rates, risk asset valuations and market returns. A discussion of these would need a much longer research note that would provide no easy answers.

As noted above, it looks very likely that short term interest rates will need to remain at historical lows over the next few years at least. At the same time, those central banks that have the capacity to do so will continue with efforts to keep bond yields anchored.

Inflation looks to be an unlikely near-term risk. In the short to medium term it is disinflationary forces that will continue to have central banks most worried. However, a world of more aggressive government deficit spending and monetisation of that debt would have more chance of generating inflation that the pre-COVID world. For that reason, it is worth considering what a moderately higher global inflation scenario could mean for policy, interest rates, currencies, risk asset prices and portfolios as currently designed.

The historical government bond returns chart below reminds how a shift to a higher inflation backdrop can impact bond returns as happened over the highlighted 1940 – 1980 period.

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It is worth contemplating that a modest pickup in inflation while interest rates remain anchored would effectively reduce real yields which, considered in isolation, could be a support to some asset pricing. It’s not that simple of course, a stagflation scenario where the modest pickup in inflation is accompanied by expectations of more sustained period of weak global growth might present a less benign backdrop for asset prices.
The aim of this short piece is not to present a view about the policy, interest rate and economic outlooks but rather to raise awareness of some major uncertainties ahead. Economic, policy and market regimes can and do change and the starting point for the COVID-19 recession raises the potential for a sustained shift in policy which has potential major implications for economies and markets over the upcoming medium term and beyond.

JANA’s portfolio construction research agenda is currently focused on related topics which include a re-examining of the role and design of defensive allocations in a world of near zero bond yields and a broader review of portfolio resilience to an unusually uncertain outlook.

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JANA respectfully acknowledges the Traditional Custodians of the land where we work and live. We pay our respects to Elders past, present and emerging. We celebrate the stories, culture and traditions of Aboriginal and Torres Strait Islander Elders of all communities who also work and live on this land.