When long-term yields challenge central banks

Description

In this episode of Think Macro, Vincent Chailley, CIO of H2O AM Group, explores an unusual market dynamic: central banks are cutting policy rates, yet long-term yields keep rising. This reversal is no coincidence - it reflects investors demanding a higher term premium in response to renewed concerns over debt sustainability, persistent inflation, and weakening institutional credibility.
We analyse why this shift matters, how it constrains economic policy, and what it could mean for investors and developed economies in the years ahead.

This podcast is distributed for informational purposes only and does not constitute advice, an offer or solicitation by or on behalf of H2O AM to buy or sell any securities, related financial instruments or other products, or to engage in any trading strategy in any jurisdiction. The analyses and opinions contained in this document represent the views of the author(s) referenced as of the date indicated and are subject to change without notice.
Before investing in any product, investors should fully understand the risks, including the market risk associated with the issuer, the financial benefits and the suitability of such products, and consult their own advisors. Investors should be aware that the value of an investment and the income derived from it may fall as well as rise, and that past performance is not a guide to future performance.

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Transcription

Speaker #0
Hello everyone and welcome for this new episode of Think Macro, where today I'd like to focus on a market phenomenon that will undoubtedly soon have macro implications. I want to talk about the rise of long-term interest rates. Over the last two, three years, central banks have cut rates and yet long-term rates have gone up. So that unusual phenomenon has serious implications. And you see that in Europe, in Japan, in the U.S. altogether. And this phenomenon, of course, has direct implications for the cost of debt, but also indirect implications. And we're going to… focus on these so but first what are we talking about what makes investors ask for more to lend to states well first credit worthiness of course as an investor if you receive a risk of non-repayment you you want to be paid more okay then there's inflation if you think inflation is going to rise or control is going to be lost on inflation. And of course, that means that the value of the money you gave, you lent to the state is going to get eroded and what you're going to be repaid with will be worth less. So second reason for an investor to ask for more payment, more, a higher interest rate. And third, More recently, and somewhat surprising in developed markets, the institutional framework. As an investor, you want to be sure that the legal framework, the rules under which you lend money are not going to change. You don't want to have a big populist government that in the course of your loan... decides not to repay for electoral reasons or something like that. So you want stability on the institutional side. You want to know the rules and you want those rules to be stable. So these three risks all taken together may mean investors want to be paid more. For 30 years, there was no issue. But over the last three years, these three risks... have come back to haunt us. First, creditworthiness. After the COVID crisis, we had to borrow more. Many states had to borrow more money to restart the economy, to make sure companies would survive. That means today a debt to GDP that comes a lot higher than before, and hence the question of the creditworthiness. If you take the numbers of the CBO in the US, and they don't have particularly pessimistic assumptions, they're saying today the debt is at 120% debt on GDP. If nothing is done on the fiscal side, if there's no major adjustment, it's going to reach 150% in 10 years and 200% in 20 years. So you can see that it can really slip out of control rapidly, debt, if nothing is done. Second, inflation. When states had to restart the economy, they had to ingest a lot of liquidity in the system, and that in a synchronized manner. So all states had to do the same at the same moment, and that did reflect the world economy up to a point we had serious inflation back then. three years ago, and we can see today, it's not easy to take it back under control. And that inflation comes as a second risk to investors. And that's the second reason for them to ask for higher rates when they lend to states. And last, more recently, we can observe that the institutional framework we thought that was just stable, particularly in developed markets, comes now in question. We've seen three years ago the U.S. government spending more, adding to the deficit at a moment of... good growth. You can see here and there governments putting pressure on the central bank to cut rates and meaning their independence might not be guaranteed anymore. We've seen again in the US a central bank just changing slightly its mandate and saying okay I'm going to focus more now on growth. at the expense of inflation. So we have that notion of institutional framework that might not be that stable anymore. Rules come under pressure. They may change for investors. And that, again, means a higher rate you ask for as an investor when you lend to these states. Now, what are the implications of higher long-term rates? First is... direct implications. Of course, that means states, households, corporates borrow at a higher price, and that comes as a break on the economy. Now, it may look small, but it's not. When you look at what happened in the US over the last five years, rates went up, the long-term rate, from three to six percent. They doubled. essentially. That's a 30% increase in price when someone wants to buy a flat or a house with a 30-year loan. So that is very significant. That's big even for wealthy households. Now there are also some indirect implications, and they're a bit more subtle, but in that sense, they're vicious. Higher long-term rates reduces the efficacy of both monetary and fiscal policy. On the monetary side, if when you cut rates and you hope for some stimulation of the economy in cutting the cost of capital, but if as a reaction, investors conclude that means more inflation in the system, long rates may well rise. And actually they did rise over the last 12 months. even if central banks were cutting rates. And that, of course, means what you give with one hand is taken back by the market through the steepening of the curve. From the other hand, what you would expect as a stimulus, of course, would come diluted a lot, if not suppressed by the rise of long-term rates. Now, same with fiscal policy. If, when you come with a fiscal package, solvency becomes an issue, then markets may say, oh, my creditworthiness has deteriorated. I want higher rates. And what you give to the economy with a fiscal package, from one hand, the market takes back. From the other hand, in raising, long-term rates. That's again what happened this year, particularly in the US, as a reaction to what the market considers as too much of fiscal deficits for the economy. So what used to be very strong and efficient tools to restart the economy in front of a shock, to support the cycle when it needed to, uh Monetary tools, fiscal tools now come as a lot less efficient because of the market reaction on long-term rates. Now, this new situation where the market reacts immediately to any decision on the monetary or the fiscal side on the long end of the curve completely changes the ability of authorities to... react and to absorb shocks. And if you just, again, take the example of the US, we've had for 30 years, a central bank, a government that on every shock would react strongly and efficiently to restart the economy after the dot-com bubble, after GFC, after the COVID crisis. Now, today, if these tools prove a lot less efficient, of course, that means we've lost essentially the Fed put. we've had for 30 years. And that's a serious change because that means that the risk be bearing as investors to hold these assets has increased. And now that takes me to the second indirect effect of the rise of long-term rates on the economy. When you are in this system where you artificially take short-term rates down more than they should, beyond where they should be, to balance growth and inflation. And you've got this focus on growth. They are lower than where they should be. You basically cut the cost of capital. And in that sense, you fuel investment in risky assets. And you may fuel too much speculation and too much inflation in price of these assets. And of course, there, I'm thinking of equities, essentially. precisely at a moment when they are getting more dangerous because, on the other hand, you've lost the efficacy of your safety nets. So in that sense, the mechanism today in the U.S. economy consists in attracting the market through cheap capital closer to a cliff. Authorities are digging for it. So that's a difficult and dodgy situation for U.S. investors we're getting in now. So in short, the rise of long-term rates has direct implications on the cost of debt, but also indirect implications in reducing the efficacy of monetary and fiscal tools and in fueling, favoring some further leverage. on assets at a moment when the opposite actually should happen. So this is sort of a poison that you need to control. And central banks, and particularly the Fed in the U.S., must today keep control of long-term rates. Now, how are they going to do that? The answer, I mean, the textbook answer is simple. You just cut costs. raise taxes. In that way, you improve your ability to repay. In that way, you slow down the economy, and that takes inflation down. You show that your countries manage in a rigorous manner. Your credibility rises. Investors are happy. They accept a lower cost of debt and to lend you at a lower price. I mean, perfect world. That works. uh it's unpopular of course and particularly in those countries at stake today that you know france the uk the us that are where they are today precisely because these measures were too difficult or they could not afford taking these measures so they need to find an alternative solution. In the US, it's already... being implemented now. And so what could that be? By construction, it's a lot more hazardous and dangerous. But that's where the U.S. is heading now in accepting high inflation and together with it, a weaker currency. The U.S. administration hopes to improve. the credit worthiness the stability of his debt at the expense of foreign investors they essentially lose twice they lose because long-term rates are higher inflation is higher and it should be you accept form of higher level less control and more credit worthiness issues so they are they the value of their debt drops And together with it, you debase the currency. And they lose a second time through the channel of the dollar. Now, the U.S. can afford to rob foreign investors. It would not be their first time. They are in a strong position. But it's still a dangerous and hazardous game. First, inflation is a lot harder to control when at 4% rather than 2%. 2% is not a magical number. It's been chosen by most central banks precisely. because inflation is a lot easier to control when at or below 2%, when at 4%, and inflation is a slippery animal. When at 4%, the risk is that inflation expectations get de-anchored and agents, economic agents, start pricing it in, in their behavior, and you sort of spiral, and the risk is then that it accelerates. And we all remember how long it took in the 80s to get back inflation under control. Ten years of forceful policy just to take it back under control. So that's a dangerous take here on inflation from the U.S. administration. Now, the second challenge and difficulty they are facing and going to face very, very soon, you need… New investors, if foreign investors are getting spoiled with their investments, they may leave and they are already actually getting away from the U.S. debt. So you need a new investor to replace them. And you need more of these because your debt is ballooning. So that's a big challenge. Now, there again, measures are being taken when the... treasury decides to issue short-term debt rather than long-term debt it alleviates the pressure on the long end of the curve now you can do that up to a point now the the us debt is already one of the shortest in the world six years average maturity so you can issue more short term of course in doing so you have to renew it more often so that can work for some time but not forever Also, the Fed recently said, OK, I'm going to interrupt, halt my QT program. I've bought a lot of debt after two big crises, sold some of it. I stopped that. Now, OK, that also alleviates the pressure, but at the expense of a still big. balance sheet at the Fed, which of course makes it fairly fragile for the future. Now, because all that will not suffice, it will not be enough, you have to push that further. And probably the next best good answer would be to incentivize, maybe force in some way, banks. financial institutions to buy more of this debt which is something you you can do i mean europeans did that back 15 years ago you just drop cut the cost of capital to when investing in the state debt that's been discussed now for some time in the us documented i think all is ready it now needs takes uh just to press the button and get there First, in controlling the yield curve and reducing the efficacy of both monetary and fiscal policy, authorities are increasing the risk investors have to bear. Second, in devaluing the value of the currency and in artificially taking rates lower than where they should be. authorities are spoiling foreign investors. And in that sense, they're pushing them away from lending. So the immediate conclusion is for them to just get away of U.S. debt and in doing so, adding to the pressure to U.S. assets. So what was seen a year ago as a risk... credibility and instability risk by the new administration now is being organized in their action. They are now devaluing the US assets. You can expect the dollar rates and as soon as the AI frenzy is over, probably equities as well to come under pressure next year again. So that's it for this episode of Think Macro. Thank you for tuning in. I hope you enjoyed and see you soon for the next one.

Description

Hosted on Ausha. See ausha.co/privacy-policy for more information.

Transcription

Speaker #0
Hello everyone and welcome for this new episode of Think Macro, where today I'd like to focus on a market phenomenon that will undoubtedly soon have macro implications. I want to talk about the rise of long-term interest rates. Over the last two, three years, central banks have cut rates and yet long-term rates have gone up. So that unusual phenomenon has serious implications. And you see that in Europe, in Japan, in the U.S. altogether. And this phenomenon, of course, has direct implications for the cost of debt, but also indirect implications. And we're going to… focus on these so but first what are we talking about what makes investors ask for more to lend to states well first credit worthiness of course as an investor if you receive a risk of non-repayment you you want to be paid more okay then there's inflation if you think inflation is going to rise or control is going to be lost on inflation. And of course, that means that the value of the money you gave, you lent to the state is going to get eroded and what you're going to be repaid with will be worth less. So second reason for an investor to ask for more payment, more, a higher interest rate. And third, More recently, and somewhat surprising in developed markets, the institutional framework. As an investor, you want to be sure that the legal framework, the rules under which you lend money are not going to change. You don't want to have a big populist government that in the course of your loan... decides not to repay for electoral reasons or something like that. So you want stability on the institutional side. You want to know the rules and you want those rules to be stable. So these three risks all taken together may mean investors want to be paid more. For 30 years, there was no issue. But over the last three years, these three risks... have come back to haunt us. First, creditworthiness. After the COVID crisis, we had to borrow more. Many states had to borrow more money to restart the economy, to make sure companies would survive. That means today a debt to GDP that comes a lot higher than before, and hence the question of the creditworthiness. If you take the numbers of the CBO in the US, and they don't have particularly pessimistic assumptions, they're saying today the debt is at 120% debt on GDP. If nothing is done on the fiscal side, if there's no major adjustment, it's going to reach 150% in 10 years and 200% in 20 years. So you can see that it can really slip out of control rapidly, debt, if nothing is done. Second, inflation. When states had to restart the economy, they had to ingest a lot of liquidity in the system, and that in a synchronized manner. So all states had to do the same at the same moment, and that did reflect the world economy up to a point we had serious inflation back then. three years ago, and we can see today, it's not easy to take it back under control. And that inflation comes as a second risk to investors. And that's the second reason for them to ask for higher rates when they lend to states. And last, more recently, we can observe that the institutional framework we thought that was just stable, particularly in developed markets, comes now in question. We've seen three years ago the U.S. government spending more, adding to the deficit at a moment of... good growth. You can see here and there governments putting pressure on the central bank to cut rates and meaning their independence might not be guaranteed anymore. We've seen again in the US a central bank just changing slightly its mandate and saying okay I'm going to focus more now on growth. at the expense of inflation. So we have that notion of institutional framework that might not be that stable anymore. Rules come under pressure. They may change for investors. And that, again, means a higher rate you ask for as an investor when you lend to these states. Now, what are the implications of higher long-term rates? First is... direct implications. Of course, that means states, households, corporates borrow at a higher price, and that comes as a break on the economy. Now, it may look small, but it's not. When you look at what happened in the US over the last five years, rates went up, the long-term rate, from three to six percent. They doubled. essentially. That's a 30% increase in price when someone wants to buy a flat or a house with a 30-year loan. So that is very significant. That's big even for wealthy households. Now there are also some indirect implications, and they're a bit more subtle, but in that sense, they're vicious. Higher long-term rates reduces the efficacy of both monetary and fiscal policy. On the monetary side, if when you cut rates and you hope for some stimulation of the economy in cutting the cost of capital, but if as a reaction, investors conclude that means more inflation in the system, long rates may well rise. And actually they did rise over the last 12 months. even if central banks were cutting rates. And that, of course, means what you give with one hand is taken back by the market through the steepening of the curve. From the other hand, what you would expect as a stimulus, of course, would come diluted a lot, if not suppressed by the rise of long-term rates. Now, same with fiscal policy. If, when you come with a fiscal package, solvency becomes an issue, then markets may say, oh, my creditworthiness has deteriorated. I want higher rates. And what you give to the economy with a fiscal package, from one hand, the market takes back. From the other hand, in raising, long-term rates. That's again what happened this year, particularly in the US, as a reaction to what the market considers as too much of fiscal deficits for the economy. So what used to be very strong and efficient tools to restart the economy in front of a shock, to support the cycle when it needed to, uh Monetary tools, fiscal tools now come as a lot less efficient because of the market reaction on long-term rates. Now, this new situation where the market reacts immediately to any decision on the monetary or the fiscal side on the long end of the curve completely changes the ability of authorities to... react and to absorb shocks. And if you just, again, take the example of the US, we've had for 30 years, a central bank, a government that on every shock would react strongly and efficiently to restart the economy after the dot-com bubble, after GFC, after the COVID crisis. Now, today, if these tools prove a lot less efficient, of course, that means we've lost essentially the Fed put. we've had for 30 years. And that's a serious change because that means that the risk be bearing as investors to hold these assets has increased. And now that takes me to the second indirect effect of the rise of long-term rates on the economy. When you are in this system where you artificially take short-term rates down more than they should, beyond where they should be, to balance growth and inflation. And you've got this focus on growth. They are lower than where they should be. You basically cut the cost of capital. And in that sense, you fuel investment in risky assets. And you may fuel too much speculation and too much inflation in price of these assets. And of course, there, I'm thinking of equities, essentially. precisely at a moment when they are getting more dangerous because, on the other hand, you've lost the efficacy of your safety nets. So in that sense, the mechanism today in the U.S. economy consists in attracting the market through cheap capital closer to a cliff. Authorities are digging for it. So that's a difficult and dodgy situation for U.S. investors we're getting in now. So in short, the rise of long-term rates has direct implications on the cost of debt, but also indirect implications in reducing the efficacy of monetary and fiscal tools and in fueling, favoring some further leverage. on assets at a moment when the opposite actually should happen. So this is sort of a poison that you need to control. And central banks, and particularly the Fed in the U.S., must today keep control of long-term rates. Now, how are they going to do that? The answer, I mean, the textbook answer is simple. You just cut costs. raise taxes. In that way, you improve your ability to repay. In that way, you slow down the economy, and that takes inflation down. You show that your countries manage in a rigorous manner. Your credibility rises. Investors are happy. They accept a lower cost of debt and to lend you at a lower price. I mean, perfect world. That works. uh it's unpopular of course and particularly in those countries at stake today that you know france the uk the us that are where they are today precisely because these measures were too difficult or they could not afford taking these measures so they need to find an alternative solution. In the US, it's already... being implemented now. And so what could that be? By construction, it's a lot more hazardous and dangerous. But that's where the U.S. is heading now in accepting high inflation and together with it, a weaker currency. The U.S. administration hopes to improve. the credit worthiness the stability of his debt at the expense of foreign investors they essentially lose twice they lose because long-term rates are higher inflation is higher and it should be you accept form of higher level less control and more credit worthiness issues so they are they the value of their debt drops And together with it, you debase the currency. And they lose a second time through the channel of the dollar. Now, the U.S. can afford to rob foreign investors. It would not be their first time. They are in a strong position. But it's still a dangerous and hazardous game. First, inflation is a lot harder to control when at 4% rather than 2%. 2% is not a magical number. It's been chosen by most central banks precisely. because inflation is a lot easier to control when at or below 2%, when at 4%, and inflation is a slippery animal. When at 4%, the risk is that inflation expectations get de-anchored and agents, economic agents, start pricing it in, in their behavior, and you sort of spiral, and the risk is then that it accelerates. And we all remember how long it took in the 80s to get back inflation under control. Ten years of forceful policy just to take it back under control. So that's a dangerous take here on inflation from the U.S. administration. Now, the second challenge and difficulty they are facing and going to face very, very soon, you need… New investors, if foreign investors are getting spoiled with their investments, they may leave and they are already actually getting away from the U.S. debt. So you need a new investor to replace them. And you need more of these because your debt is ballooning. So that's a big challenge. Now, there again, measures are being taken when the... treasury decides to issue short-term debt rather than long-term debt it alleviates the pressure on the long end of the curve now you can do that up to a point now the the us debt is already one of the shortest in the world six years average maturity so you can issue more short term of course in doing so you have to renew it more often so that can work for some time but not forever Also, the Fed recently said, OK, I'm going to interrupt, halt my QT program. I've bought a lot of debt after two big crises, sold some of it. I stopped that. Now, OK, that also alleviates the pressure, but at the expense of a still big. balance sheet at the Fed, which of course makes it fairly fragile for the future. Now, because all that will not suffice, it will not be enough, you have to push that further. And probably the next best good answer would be to incentivize, maybe force in some way, banks. financial institutions to buy more of this debt which is something you you can do i mean europeans did that back 15 years ago you just drop cut the cost of capital to when investing in the state debt that's been discussed now for some time in the us documented i think all is ready it now needs takes uh just to press the button and get there First, in controlling the yield curve and reducing the efficacy of both monetary and fiscal policy, authorities are increasing the risk investors have to bear. Second, in devaluing the value of the currency and in artificially taking rates lower than where they should be. authorities are spoiling foreign investors. And in that sense, they're pushing them away from lending. So the immediate conclusion is for them to just get away of U.S. debt and in doing so, adding to the pressure to U.S. assets. So what was seen a year ago as a risk... credibility and instability risk by the new administration now is being organized in their action. They are now devaluing the US assets. You can expect the dollar rates and as soon as the AI frenzy is over, probably equities as well to come under pressure next year again. So that's it for this episode of Think Macro. Thank you for tuning in. I hope you enjoyed and see you soon for the next one.

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