Wed. Dec 1st, 2021

The author, Morgan Stanley Investment Management’s Chief Global Strategist, is author of ‘The Ten Rules of Successful Nations’

One of the major mysteries in the world economy is why, although inflation is making a strong comeback, long-term interest rates have barely moved in recent months.

So far, analysts have explained this strange market behavior as a symptom of the pandemic, driven by fears of another surge in cases, or massive central bank asset purchases, or – above all – a belief that the current inflation peak is temporary.

None of these explanations hold up well in the light of recent data, but there is one explanation that does: the world is in a debt trap.

Over the past four decades, total debt has more than tripled to 350 percent of global gross domestic product. As central banks lowered interest rates to their recent lows, easy money flowing to equities, bonds and other assets helped increase the volume of global markets of the same size as global GDP to four times larger. Now the bond market may feel that the debt-soaked and asset-inflated world economy is so sensitive to interest rate hikes that any significant rise is simply not sustainable.

Surely, if all the standard explanations fall apart, something deeper must be going on. Despite the increasing Covid case load, fears of its economic impact have given way to the assumption that vaccines and new drugs will alter Covid in a normal part of life, such as flu. Global data shows that consumers go back to shopping and going to restaurants at near pre-pandemic levels.

At the height of the crisis, the US Federal Reserve bought 41 percent of all new treasury spending, but long-term yields remained close to record lows, even after the Fed and other central banks began signal in early autumn their plans to terminate their purchases. In addition, central banks buy bonds of all duration, so why are rates rising now only for shorter-term bonds?

This is where the inflation scenarios come in – either that the current rise will pass as pandemic-induced supply shortages ease, or that the world enters an era like the 1970s, with inflation embedded in the system and people’s psyche.

Evidence is growing that inflation is not as “perishable” as central banks have insisted. Attention is focused on headline inflation, which last month reached a record high of three decades of more than 6 percent in the US. But nuclear inflation measures – which exclude volatile prices such as food and energy, and serve as a better indicator of long-term trends – have risen globally and are currently more than 4 percent in the US. Wages also face long-term upward pressure: there are now more than six jobs for every unemployed American, a two-decade high.

Earlier this year, there was reason to hope that a rise in productivity could continue, limiting long-term inflation, but it has faded. Surveys show that people who work from home put in longer hours to generate the same level of output.

Global bond markets are beginning to price expectations that higher inflation and growth will force central banks to raise short-term rates from next year. In fact, rising short-term rates are putting the world’s government bond markets on course for their worst year of yield since 1949.

Yet the yield on 10-year government bonds is now far below the inflation rate in every developed country. The market is probably intuitive that, no matter what happens to inflation and growth in the near term, long-term interest rates cannot move higher because the world is far too much to blame.

As financial markets and total debt grow as part of GDP, they become increasingly fragile. Asset prices and the cost of servicing the debt are becoming more sensitive to rate hikes, and now represent a double threat to the world economy. In recent tightening cycles, large central banks have typically raised rates by about 400 to 700 basis points.

Now, much lighter sharpening can put many countries in economic trouble. The number of countries in which total debt amounts to more than 300 percent of GDP has risen from half a dozen to two dozen over the past two decades, including the US. An aggressive rate hike could also deflate higher asset prices, which are usually also deflationary for the economy. Those vulnerabilities will explain why the market seems so focused on the “policy error” scenario, in which central banks are forced to raise rates sharply, cause the economy to stumble and eventually push rates back.

In fact, the world is caught in a debt trap, suggesting that while the refusal of long-term rates to rise significantly is new and unexpected, it can also be completely rational.

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