[Finance] The “Silver Lining” in Rising US Treasury Yields — Are High Interest Rates Bad?
WSJ Decoding Series
Interest rates are rising globally.
In the United States, the 10-year Treasury yield has surpassed 5%, and long-term interest rates in Japan and Europe are also at their highest levels in decades. Generally speaking, high interest rates act as a headwind for the economy.
Mortgage and corporate borrowing costs rise, while capital investment and consumption are suppressed. Concerns also arise that if interest rates rise, funds will shift from stocks to higher-yielding bonds.
However, the global economy is surprisingly resilient, and in the US in particular, the economy has not collapsed significantly despite high interest rates. Corporate earnings remain solid, and AI-related investment continues.
This article was written from the perspective of “Can rising interest rates necessarily be called bad?” Let’s decode the content.
WSJ dated 9/20
“ The Silver Lining in Soaring Interest Rates: The Economy Can Handle Them ”
Silver lining: The original meaning is the phenomenon where the edges of clouds shine silver as sunlight shines from behind dark clouds. It has come to mean “a ray of hope or light.”
First, the question posed by the article is simple.
If the economy can withstand such high interest rates, hasn’t the “normal interest rate level” that the economy can withstand risen in the first place?
The key to this is the neutral rate of interest.
💡What is the neutral rate of interest?
A neutral rate of interest is the interest rate level that neither stimulates nor restrains the economy.
If interest rates are lower than the neutral level, monetary policy tends to be accommodative, and conversely, if they are higher than the neutral level, it becomes restrictive. However, the neutral rate cannot be directly observed.
Usually, it is estimated using models based on GDP, inflation, potential growth rate, etc. The “Taylor rule” is famous. Since the neutral rate is not a fixed answer, it is only an estimate. The value changes drastically depending on the settings (parameters), so the Fed does not use the neutral rate as a direct policy target. The Bank of Japan also publishes estimates, but the range is wide (approx. -0.9% to +0.5%). Fed Governor Warsh also shows a cautious stance on the neutral rate, stating,
“While academically useful, it is not something that can be used directly for today’s policy decisions.” Nevertheless, the neutral rate is extremely important for the market. This is because if the neutral rate rises, it is thought that the “normal level to which policy rates will return in the future” will also rise.
💡Fed’s neutral rate estimate is also rising
In the Fed’s long-term policy rate outlook introduced by the WSJ, the median long-term interest rate, which is close to the neutral rate, was raised from 3.1% to 3.25%.
Goldman Sachs evaluates this increase as larger than expected. Furthermore, Oxford Economics anticipates the possibility that the US neutral rate will rise by another 0.5 percentage points over the next five years. It also expects an increase of about 0.25 percentage points for the Eurozone. In other words, an increase in the neutral rate means that there is a possibility of transitioning from an “era where low interest rates are normal” to an “era where slightly higher interest rates are normal.”
💡”Good rise” and “bad rise” of the neutral rate
This is the most interesting part of this article.
When we hear about rising interest rates, we tend to think of them as bad news. However, the meaning differs completely depending on the reason why the neutral rate rises.
Good neutral rate rise
The WSJ is focusing on AI investment and productivity improvement. If capital investment in AI boosts productivity,
→ Potential growth rate rises → Corporate profits, income, and tax revenue increase → The economy can withstand higher interest rates
If this flow is created, the fact that the neutral rate is high is not necessarily a bad thing. Goldman economists also expressed the view that “the fact that the economy can maintain higher interest rates is a favorable sign, indicating the possibility of high underlying growth potential.” In other words, it is the view that the economy is not weak because interest rates are high, but that it can withstand high interest rates because the economy is strong.
However, on the other hand, not all factors that push up the neutral rate are welcome, and there is also a “bad interest rate rise.”
A prime example is the increase in government debt.
If government debt swells and the issuance of government bonds continues to increase, higher yields will be required to get investors to buy more government bonds. In other words,
Government debt increase → Government bond supply increase → Investors demand higher yields → Long-term interest rates rise
This is the flow. This is completely different in nature from the “good interest rate rise” due to productivity improvement.
💡This leads to the decomposition of long-term interest rates
There is a particularly interesting sentence in this article:
the point that the rise in neutral rate estimates is prompting the sale of long-term government bonds. Long-term interest rates can be roughly decomposed into
future average expected short-term interest rate + term premium. If the neutral rate rises, it leads to the view that “future policy rates will not be as low as before.” Then,
average expected short-term interest rate rises → long-term interest rates fall.
On the other hand, if anxiety about government debt increases or government bond supply strengthens,
term premium rises → long-term interest rates rise.
In other words, even with the same “long-term interest rate rise,” the meaning is completely different depending on whether it is due to growth potential/neutral rate rise or fiscal/supply-demand factors. Note that the average expected short-term interest rate can be confirmed with data published by the San Francisco Fed.
Note that the average expected short-term interest rate can be confirmed with data published by the San Francisco Fed.
💡It is not necessarily the case that the same thing is happening all over the world
The article is cautious here as well.
Regarding the US,
AI investment
→ productivity improvement
→ rise in potential growth rate
→ rise in neutral interest rate
is a relatively easy explanation to understand. However, there are dissenting opinions regarding Europe.
An ING economist pointed out, ‘The story that the neutral interest rate has risen in the US is convincing. However, in Europe, we do not see a story of productivity growth or a rise in potential growth rate’:
In other words, one cannot lump the whole world together by saying rising interest rates mean the economy has become stronger.
💡 Why did the era of low interest rates continue?
Looking back at the background, since the 1980s, the neutral interest rate has declined over the long term. Reasons cited include increased demand for savings due to aging populations and lower corporate investment demand. Furthermore, in the 2000s, there was the ‘Global Saving Glut’ pointed out by former Fed Chair Bernanke
. In addition, trade surplus countries like China invested huge amounts of capital into safe assets such as US Treasuries, which pushed global interest rates down even further.
However, Warsh stated at the recent FOMC, ‘The era of that savings glut is over, and we have now entered an era of a global investment surge.’ This includes AI investment.
If we are truly shifting from a world of ‘excess savings’ to one of ‘excess investment,’ the era of low interest rates itself may be structurally coming to an end.
💡 ‘High interest rates’ are not ‘bad’
The biggest lesson from this article is that one should not look only at the level of interest rates.
What is important is ‘why interest rates are high.’
If the rise in interest rates is due to productivity improvements or a rise in potential growth rates, it may indicate economic strength.
On the other hand, if the rise in interest rates is due to government debt or a deterioration in the supply and demand for government bonds, it might actually be a warning for the future. Even at 5%, the meaning is completely different.
💡 Looking at it in terms of tides, winds, and waves
Considering the recent ‘break above 5%’ for the US 10-year Treasury,
the immediate waves are:
strong PMI
+ Fed’s hawkish remarks
+ expectations for additional rate hikes
+ weak 5-year note auction
As a result, US Treasury yields from 2-year to 30-year rose in unison.
However, there may be a much larger tide beneath that. That is the rise in the neutral interest rate itself.
Looking only at a daily rise of about 15 bps, it can be explained by ‘the Fed is going to raise rates again.’ But if you think in terms of years, the question arises whether the world itself has changed into an economy that requires higher interest rates than before.
When you think that far, this 10-year Treasury break above 5% looks a bit different from just a one-day surge in interest rates.
📗 Finally
Low interest rates are not necessarily good news.
In the past, low interest rates were also a signal reflecting ‘weak future growth potential.’ Conversely, if the rise in the neutral interest rate is the result of productivity improvements and a rise in potential growth rates, there is a ‘ray of light’ even within high interest rates.
However, whether that interest rate rise is due to growth, inflation, fiscal policy, or supply and demand—if you don’t break that down and only look at ‘interest rates went up or down,’ you won’t understand the true meaning.
Look at the content, not just the interest rate level.
I think this has become increasingly important for reading long-term interest rates.
(Reference article)
Thank you for reading.🙇♀️