As recently as November 2018, ten-year U.S. government bonds paid an interest rate over 3 percent. That yield gradually fell as the Federal Reserve shifted from a stance of hiking interest rates to cutting them. And in the last couple of weeks, ten-year bond yields have absolutely cratered, falling below one percent for the first time ever. On Friday, they even briefly dipped below 0.7 percent. While the stock-market turmoil has gotten the most attention, these ultra-low yields on safe, long-term bonds are a warning light that the coronavirus situation is likely to have a serious, negative, and persistent effect on the economy.
Long-term interest rates are a barometer of economic-growth expectations. Two reasons that interest rates have fallen so much around the world over the last few decades is that population growth has slowed down and productivity growth has been disappointing. These are both factors that reduce overall expectations of economic growth, and therefore interest rates. When growth is expected to be strong, interest rates tend to go up because demand for investment capital starts to outstrip supply. When the growth outlook is weak, few people are interested in borrowing and investing and so the interest rate — which is effectively the price of capital — falls.
Of course, there are other matters that long-term interest rates react to. Long rates are sensitive to moves in short rates — in particular, if central banks are expected to cut short-term interest rates in the future, that will tend to cause long-term interest rates to fall now. The Fed has already cut short-term interest rates by half a percentage point in response to the coronavirus crisis and it is widely expected to cut more over the coming months. But the sharp fall in long-term interest rates reflects not just an expectation that the Fed will cut rates soon but that it will keep them low for an extended period — something the Fed would be expected to do if the economic drag from coronavirus were going to be prolonged and the economy would require extended stimulus even after the epidemic has abated. The drop in long-term interest rates is also partly attributable to a significant decline in expected inflation, which is another indicator of expected economic weakness due to reduced consumer demand.
Ernie Tedeschi, a macroeconomist at the investment research firm Evercore ISI, also points to the issue of term premium: With increased uncertainty over the economic and interest-rate outlook, investors are increasingly willing to pay a premium to obtain a very safe asset that pays a fixed return for a long time. That’s another factor that may be drawing investors to long-term government bonds and pushing down their yields. Tedeschi sees three simultaneous phenomena that push long-term bond yields down — investors expecting looser Fed policy, investors expecting lower inflation, and investors desiring the certainty of a long term — all as signs that investors are increasingly worried about growth in the U.S. and abroad.
Tim Duy, an economics professor at the University of Oregon, offers a less alarming explanation for at least part of the interest rate move: Falling long-term interest rates will cause mortgage rates to fall. This is good news for home buyers, but it means banks have to prepare for existing borrowers to pay off their mortgages and refinance at lower rates. Those prepayments will be bad for those banks (they’ll be losing loans that pay higher interest rates and making new ones that are less lucrative) so right now banks are hedging their positions by buying long-term government bonds, which can be expected to go up in value at the same time their mortgage portfolios get hit. This can lead to a self-reinforcing cycle: Long-term rates are falling, so banks need to buy long-term bonds, which bids up their price and causes long-term rates to fall even more. (Remember, bond prices go up when bond yields go down.)
“I’m an optimist,” says Duy, who leans toward this explanation of the interest-rate moves and thinks it is possible we will avoid a coronavirus-related recession. If we do have a recession, he expects it to be a mild one along the lines of the recession in 1990-91, not a 2008-style crisis. Like some other economists I’ve spoken with in recent weeks, he emphasized that recoveries from macroeconomic crises caused by natural disasters tend to be more rapid than recoveries from crises due to other causes.
Still, Duy acknowledges other possible explanations for the sharp fall in interest rates that are more alarming: that they are a sign that investors expect a slower and more prolonged recovery from a recession that may involve extended shutdowns of commerce around the world; or that they reflect an overall worsening of economic expectations that has not yet fully priced into the stock market, which rose slightly last week even as bond yields continued to fall.
“Bonds were moving ahead of stocks in this whole incident,” says Duy. If that’s still the case, stocks may be in for a rough week ahead.