The other day, one of OppenheimerFunds’ Senior Consultants reached out to me in utter panic: A fund manager of some gravitas and notoriety had just made a pronouncement that the 10-Year Treasury yield is going from 1.8% to 6% on the back of rising inflation and, consequently, all he is buying are Treasury Inflation Protected Securities (TIPS).
The Consultant wanted to know: What is he supposed to tell his clients?
My response was that he and his clients should file that pronouncement under confusing a secular story with a cyclical anecdote.
It is true that headline inflation in the U.S., as measured by the Consumer Price Index (CPI), has been heading higher recently. However, that is entirely due to base effects, meaning that inflation has been so low in recent years that even a small increase in CPI will look like meaningfully higher inflation now. A year ago, the commodity complex was flat on its back and prices were low. As commodity prices have recovered, headline inflation in the U.S. has inched up. However, once these base effects have fully flowed through, it will be back to the usual low-inflation outlook. You can see the evidence of that in core inflation, which remains subdued.
The Big Picture on Inflation
But even that is really missing the big picture. I am tempted to mention the forest and the trees and other such clichés.
The key point, however, is that the longer-term thesis of why interest rates, and inflation, are going to remain low for a long period of time has nothing to do with the U.S. business cycle. Rather, it has a lot more to do with Asia.
Focusing on the U.S. business cycle at this point is like focusing on the fever when the root cause of the fever is infection. If the infection is not eliminated from the body, the fever may go up and down but the sick patient will not be cured anytime soon.
Former Federal Reserve Chairman Ben Bernanke articulated all the way back in 2004 that the root cause of the malaise facing the world was the savings glut in Asia―East Asia to be specific. As billions of people were incorporated into the global production system, their incomes grew, but they also saved a lot. Some of those savings were deployed at home, but a lot of it was exported.
The world was just fine when those excess savings could be exported from places like China, and the developed world was happy to lever itself. However, that ended with the Global Financial Crisis (GFC) that began in 2008.
For the secular pressure to end, those savings rates have to go down. In other words, the infection has to be eliminated. Has that happened?
The answer is a categorical, “No!”
Why Global Inflation, Interest Rates Will Stay Low
Actually, savings rates in East Asia (as a percentage of GDP) are higher now than they were in 2007-2008. Furthermore, due to the growth in GDP, which is faster than in developed markets, the size of the savings glut relative to the developed markets’ GDP is even bigger.
Here is a simple picture from Brad Setser, a Senior Fellow at the Council on Foreign Relations (Exhibit 1).
According to his calculations, Asian surplus economies saved $2.8 trillion in 2005. Now they are saving around $7 trillion.1
What is different today, compared with what was happening before the GFC, is that these savings are being deployed in new investments within China and creating an unsustainable debt bubble of gargantuan proportions.
At some point, the Chinese investment cycle will have to slow. These huge savings will then either have to be exported―to developed markets, of course, as no other countries can absorb such large amounts―or China’s growth rate will drop precipitously―which Chinese policymakers will try to avoid at all cost.
The bottom line is that the root causes of deflationary pressures in the world―high emerging market savings rates and their inability to absorb and deploy all of those savings in a sustainable manner―have not been resolved. Until that happens, I believe inflation and interest rates are going to remain low on a global basis.
That is not to say that at various points business cycles won’t accelerate in some places in the world and headline, or core inflation for that matter, won’t start picking up. The point is that such cyclical inflation pressures will not be sustained. For long-term investors, it’s not the short-term ups and downs, but the sustainability that matters.
If inflation in the U.S. picks up, it will only be temporary, in my view. And if interest rate markets sell off as a result, it will be another buying opportunity for long-term investors.
The idea that 10-Year Treasury yields are going to 6% is clearly hyperbole, the purpose of which is to make an exaggerated point. But if rates go to 3%―and even that has only a slim chance in my view―rest assured they will be back down to 1.5% soon after.
1 “Asia’s Persistent Savings Glut,” Brad Sester, Senior Fellow, Council on Foreign Relations, 10/25/16.↩
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