Notes from a conference on Long-term interest rates since 1750

Why is it important?

The market uses DCFs, NPVs analyses to compute the value of securities.
Therefore, the discount rate is a major driver of valuation.

Those 2 following graphs show the relationship.
From 1965 to 1980, the S&P gained an average of 2.5% per annum (despite 9% annual nominal GDP growth). Bond yield shot up from 4% to 13%, and equity returns were negative on a real basis.

From 1980 to 2000, the S&P gained 9.5% pa and from 1980 to today, 5.7% pa.
Bond yields collapsed to 6% and 3.5% respectively. Annual nominal GDP growth was 6.4%pa and 5.6%pa.

If LT bond yields were to revert towards 6-8% as the consensus is expecting, then equities will be crushed.

Terry Mills and Geoffrey Wood* wrote a paper on Interest Rates in Britain since 1750.
The main findings are the following:
- Concept of different money supply regimes
- Interest rates and inflation have a positive relationship
- But this only started from the 1930’s
- Real bond yields averaged 2.55% over the period, but this was volatile, the distribution has fat tails and real yields shrunk between 1915 and 1964.
- Government borrowing has had no impact on bond yields since the end of the Gold Standard

I believe point 2 and 5 are the major ones.

The academics behind the paper argued at this conference – a bit against their findings - that bond yields would rise from now on given the debt levels.
However, it is suggested that long-term savings rate can rise in times of high public borrowing as households anticipate future higher taxes to pay for it. They reckon households start saving 5 years ahead of future taxation.

Then, it is not impossible that we are going to see higher savings rate in countries like the US or the UK, in anticipation of future higher taxes (promised by the Tories for instance).
Hence, as in Japan since the 1990’s, government borrowings would be covered by higher demand from the household sector.

Bond yields would therefore not move much and this asset class would rally.
This scenario is bullish for equities as long as there is growth in cash flows – which has to be discussed if households increase their savings obviously.

In conclusion, I am probably wrong thinking higher bond yields are unlikely in the next few years. But it looks like the key piece of information is overlooked: the leverage in the system.
If long-term yields double as suggested, the economies would collapse.
I then cannot see how buying commodities for which there will be no demand will protect your portfolios. Gold went down 25% in October 2008 when it was meant to save you.

Happy to read your comments,

JJ

*Two and a half Centuries of British Interest Rates, Monetary Regimes and Inflation, Terence C.Mills and Geoffrey E.Wood, October 2009