We need to talk about interest rates

The sharp rise in yields across all segments of the curve, of between 40 and 50 basis points since the end of June, marks a new phase in the shift in bond markets that began in 2022 and reflects the structural transformations that the global economy faces. This poses a new source of concern if this trend intensifies, given that global public debt is now approaching the psychological threshold of 100 trillion dollars, with that of countries such as the US exceeding 40 trillion dollars. This brings it close to the limits set by Ferguson’s Law, which states that any great economic power risks ceasing to be one when the interest payments on its public debt exceed its defence spending. At that point, servicing past debts requires more resources than ensuring future security.

Considering that the natural rate of interest is the one that balances savings and investment and is compatible with price stability, the reality is that, after more than a lost decade for gross capital formation following the great financial crisis, since the pandemic there has been an increase in funding needs associated with defence, artificial intelligence (AI), population ageing and the energy transition. This trend has accelerated in recent quarters, driven by the race among major tech firms to lead the AI revolution and their increasing direct recourse to financial markets. From this perspective, we are witnessing a normalisation of interest rates following a prolonged period characterised by economic and financial anomalies, such as negative yields or the use of unconventional instruments by central banks to combat the risk of Western economies following in the footsteps of Japan. This normalisation has placed the average interest rate of the OECD’s main long-term debt benchmarks at 2008 levels, around 3.7%. The normalisation is also evident in the upward revision of neutral rates by central banks such as that of the euro area, which has now placed them between 2% and 2.5%. At the same time, these institutions are reducing their footprint in the markets, with a balance sheet that has shrunk from 65% to 37% of the euro area’s GDP, and are refocusing monetary policy on benchmark rates and weekly auctions.

If we break down the interest rate movements of recent months into the real component and inflation expectations, the real yield would account for most of the rise, both in the 10-year bond and for the 30-year benchmark. This phenomenon is particularly evident in the US, where real rates have settled between 2.5% and 3% at the long end of the curve, in contrast to the still negative levels of early 2022, while medium-term inflation expectations barely exceed 2%. This development reflects the degree of confidence in central banks’ ability to bring inflation back down to target levels, as well as changes in the balance between savings and investment, and optimism about the impact of investment in AI on long-term growth. It also helps to explain the apparent contradiction between the increase in the risk-free asset’s yield and the strong performance of stock markets over the summer.

If, alternatively, we break down long-term yields between expectations regarding future central bank movements and the term premium – that is, the cost of hedging against unforeseen fiscal or monetary risks – most of the increase so far this year appears to be explained by an upward recalibration of the level of rates required to achieve inflation targets. However, with the exception of the usual suspects of recent years, such as France and the United Kingdom, the term premium has not increased significantly. This overly tolerant attitude may be explained by the fact that the rise in the risk-free rate also reflects concerns about fiscal policy.

Ultimately, it seems that the recent rise in yields is not due to excessive investor concern over monetary or fiscal imbalances, but rather central banks’ commitment to higher neutral rates in order to combat the effects of supply shocks, as well as higher equilibrium rates to accommodate the new funding demands of both the public and private sectors. Therefore, the expectation, albeit not without risk, is that investments in AI will quickly translate into productivity, potential growth, and corporate profits, enabling the stabilisation of public debt dynamics. Nevertheless, the degree of optimism and calm vary by region, as demonstrated by the surprising interventions of the US Treasury in the bond market, both directly through increased purchases of government debt and indirectly via its actions in the currency markets alongside the Japanese authorities.