In case you missed it, last Friday marked a once-in-several-lifetimes event in the financial markets. Interest rates on long-term government bonds around the developed world made new lows in response to continuing European turmoil and the threat of the global recovery stalling out. We are not just talking low rates; we are talking serious, big-time, record smashing lows.
The U.S. 10-year Treasury bond interest rate fell to 1.46 percent. That eclipsed the lowest level previously recorded, 1.54 percent in 1946. Germany, France, Holland, Austria and Finland broke new ground going back even further, since their issuance of government bonds predates the relatively young U.S. Treasury market. Very impressive, but the Grand Prize goes to the Brits: the UK Gilt [British bond] rate fell to 1.47 percent, the lowest since the Bank of England began keeping records during the rule of Queen Anne in 1703.
What these countries have in common is the perceived safety of their sovereign bonds, safekeeping during periods of heightened risk. This is the so-called "safe-haven" trade that occurs as investors take money out of risky assets like stocks, and foreign governments with current account surpluses seek a safe place to stash their excess cash. Government bonds issued by the countries considered the least risky (including the U.S.) are the repository of these funds, resulting in higher bond prices and therefore lower interest rates.
The safe-haven trade emerges any time there is financial or geopolitical turmoil, but this one is a humdinger. No question that there are spooky things lurking out there that have investors worried enough to accept negative real interest rates (after inflation), but surely nothing remotely as risky as World War II, the Cold War, the Great Depression or the untimely death of William of Orange. So how to explain the lowest bond yields ever?
One explanation is the emergence of the modern Central Bank. The large-scale manipulation of monetary policy (influencing the supply of money and the level of interest rates) is a relatively blunt instrument best suited to maintaining stable prices through inflation targeting. Unfortunately, since the 1990s, monetary policy has been applied as a poor substitute for the fiscal responsibility reflexively avoided by elected legislatures. This has resulted in a pattern of artificially low interest rates over extended periods.
Secondly (and perhaps more importantly), there has been a virtual explosion of liquidity worldwide. Millions of investors in Asia, Latin America and the former Soviet Union are beneficiaries of the global economic expansion and now have money to invest, while their governments have amassed impressive capital surpluses through foreign trade. Many of these dollars (Euros, reals, rupees etc.) are seeking a safe resting place in the government bonds of the safest developed countries, driving global interest rates lower.
Meanwhile, we may not have found the ultimate bottom. Depending upon developments in Europe over the next few weeks, it is not inconceivable that long rates may hit 1 percent. Truly historic.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.