September 20, 2023
by John Rapley
‘Over and done.’ So rose the chorus when news dropped last week of a surprise contraction in the Canadian economy and many economists concluded that the Bank of Canada’s job was done. With inflation moderating and the economy slowing, they reasoned, interest rates will go no higher and will, by next year, start coming back down. Canadians who accumulated mortgages during the cheap-money days, and who are now buckling under the biggest debt burden of any G7 country, will be keen for relief.
But while we’re probably near the peak of interest rates, we’d be getting ahead of ourselves if we expect them to drop very much any time soon. For starters, it’s too early to say if the recent slowdown reflects structural developments in the economy or merely cyclical ones, exacerbated by the summer’s extreme weather. Some economists thus say a rebound in inflation is possible later this year, and that while it will remain cautious of hiking rates too much, the Bank of Canada is unlikely to abandon its tightening bias any time soon.
More importantly, when we look to the longer term, there are reasons to expect that higher interest rates may be here to stay. Over the past couple of years we’ve been laser-focused on central bank policies, trying to determine which way they’ll move. But in the meantime, we’ve overlooked what’s been going on behind the scenes.
In particular, there appears to be a sea change under way in global bond markets, which have a bit of a chicken-and-egg relationship with interest rates.
Western government debt levels surged in the pandemic, those of many emerging markets have held more steady, leaving many developing countries in comparatively better fiscal shape. And so while Western governments were once the safe bets and emerging markets paid a risk premium, increasingly, developing countries are looking like good credit bets, with their bonds in consequence becoming more attractive. Western governments now have to compete for credit.
Add it all up and it’s looking increasingly likely that the decades-long bull market in Western government bonds has given way to what may be an equally long bear market. That will keep upward pressure on rates from here on in.
Western governments are projected to borrow even more in the future. To attract more money, they’ll need higher-yielding bonds, which will further require them to have higher interest rates.
Anyone who built up a lot of debt in the easy-money years, when it looked like interest rates would stay low forever, will have to adapt to this new regime.
This will have important implications for the investment landscape. Not just bond markets, but asset markets more generally, have been on something of a tear since the 1980s. Even though there have been crashes along the way, the long-term trend has only been upward. But this period resulted from an exceptional blend of government policies that lowered interest rates and cut corporate taxes. That trend, too, appears to have now run its course. As the populations of Western countries age, governments will have to spend more, which will put upward pressure on both taxes and borrowing.
As a result, the years of snapping up assets and then counting your gains may give way to a future of lower returns. Those who are hoping to be rescued by a return to low interest rates may find themselves waiting in vain.
