The great rise (and coming fall) in rates

This post highlights a few selected arguments from my latest client note on the drivers of rates, and their outlook.

Bond yields have increased meaningfully across advanced economies since 2021. This partly represents a retracing after the pandemic, but the more striking feature is the reversal of the broad direction of rates over the past 40 years. And rates have moved sharply higher over the past several weeks, reaching levels not seen since the early 2000s.

There are several common explanations for the rise in yields. Inflation has been more persistent than expected, leading markets to price a higher path for policy rates. GDP growth, particularly in the US, has also been resilient – likely contributing to a higher equilibrium real rate. And investors have become more concerned about fiscal risk, notably in countries like the US and France.

But these explanations are better understood as symptoms of a deeper change in the global economic regime. Macro policy and outcomes are importantly downstream of geopolitical developments. And the shift from a market state regime towards state capitalism has important implications for rates, through structural changes in global capital demand and supply.

For the few decades from around 1990, the global economy was broadly characterised by an abundance of savings relative to investment opportunities. Governments generally exercised fiscal restraint, private investment was subdued, and large pools of global savings searched for safe assets. Central banks were also substantial buyers of government bonds.

This was underpinned by a particular geopolitical environment. The Cold War peace dividend; the extension of globalisation; reserves’ accumulation allocated into the US hegemon; and so on. This environment generated sustained downward pressure on interest rates.

But state capitalism, emerging partly in response to geopolitical rivalry, is a much more capex-intensive regime. Government borrowing requirements are expanding substantially, in response to strategic demands for military spending, industrial policy, and more. Private sector investment is increasing sharply: from AI-related sectors to a broader reindustrialisation process. Private sector demand for long-duration capital is growing.

At the same time, many sources of capital supply to the government are under pressure. Foreign demand for US Treasuries is weakening, central banks have been shrinking their balance sheets, and current surplus economies are likely to be exporting less capital to deficit economies. These dynamics are likely to continue, although with substantial variation in exposure across economies.

This is an important reversal. The global economy is moving from a savings-abundant environment towards one in which available capital is becoming scarcer. This implies higher interest rates. Investors need to be compensated for holding long-duration government debt in a world of heavy issuance and greater fiscal and policy uncertainty.

It is plausible that this process has further to run. This is a structural reset in rates, driven by enduring shifts in global capital demand and supply. It is not simply a function of near-term inflation expectations that may soften when, for example, the Hormuz Strait fully reopens.

However, Stein’s Law should be kept in mind: ‘If something cannot go on forever, it will stop’. Many governments will not be able to live with interest rates at these levels; already markedly higher debt servicing costs are causing fiscal stress. Again, there is significant variation across advanced economies in their exposure to these pressures.

As previous notes have discussed, there is an increasing likelihood of unorthodox macro policy to limit or reverse these increases in rates: from financial repression and fiscal dominance to coercive demands for foreign financing (capital wars) and adjusted monetary policy.

On this latter point, see my recent remarks on central bank independence in the Financial Times:\.
Over time, rates will become a political variable as much as an economically-driven variable.

These dynamics and policy behaviours are very different than those seen over the past few decades. It is important not to anchor expectations with respect to rates on the experience of the past few decades of the market state. Macro policies and outcomes will be profoundly reshaped by the structural regime change process that is underway.

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