Cost of money

Yields may remain elevated for an extended period

Financial markets continue to adapt to the expectation that the cost of money is likely to remain high in the foreseeable future. On Monday, the yield on 10-year US government bonds crossed the psychologically important level of 5 per cent after 16 years. This resulted in a correction in bond and equity markets across the world. In the Indian stock market, the benchmark BSE Sensex declined by about 1.3 per cent. The immediate reason for increasing bond yields can be attributed to the view that policy interest rates in the US will remain higher for longer. US Federal Reserve Chairman Jerome Powell and other policymakers have underscored in their recent public appearances that interest rates will need to be kept at higher levels to bring down the inflation rate closer to the 2 per cent target on a sustainable basis. Although the financial market expects the Fed to hold the policy rate steady in its upcoming meeting next week, it is also factoring in the possibility of at least one more rate increase in the current cycle.

However, aside from the immediate policy compulsions of the Fed, the US economy is arguably witnessing structural changes, which could keep the cost of money elevated for an extended period. The Budget deficit in the US, for instance, has structurally moved up compared to what happened in recent decades. This has increased the demand for financial savings, which can push up the cost of money on a durable basis. It is also worth noting that the appetite for US government paper from countries such as China, which was funnelling excess savings into US treasuries for many years, has gone down markedly for a variety of reasons. Further, the supply of bonds is likely to remain elevated at a time when the Fed is reducing the size of its balance sheet. All put together will keep upward pressure on yields.

Along with the higher demand for savings by the government, the overall supply and demand for savings are also witnessing significant changes. To gauge what led to lower interest rates in the recent decades and what the future may hold, economists at Bloomberg studied data sets spanning half a century and estimated, adjusted for inflation, the natural rate of interest in the context of 10-year US government bonds fell from 5 per cent in 1980 to less than 2 per cent in the past decade. The natural rate is broadly referred to as the interest rate that balances savings and investments. Based on a number of factors, including the increased Budget deficit, the Bloomberg model shows an increase of about one percentage point in the natural rate from 1.7 per cent in the 2010s to 2.7 per cent in the 2030s. This would mean the 10-year government bond yield in nominal terms would settle between 4.5 per cent and 5 per cent, with risk skewed to the upside.

If things go as have been forecast, the coming years will be vastly different from those gone by. Systematically higher interest rates in the US, and possibly in other advanced economies, will alter the global fund flow dynamics. A higher cost of capital would not only affect global growth prospects, but also increase financing and liquidity risks for many developing economies. For a country like India, it would be imperative to address macroeconomic stability risks and increase domestic savings.