Lower Real Rates – It’s A Seven Hundred Year Trend

A new paper by Harvard economist Paul Schmelzing, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018, puts the secular stagnation debate into a historic context by looking at interest rate trends over the past 700 years. Schmelzing finds that the recent decline in real rates is entirely in-line with long-term trends and irrespective of policy support, permanently negative real rates could occur.

Data Collection and Constructing the Global and Safe Asset Series

Schmelzing utilized historical archives (primary sources, published secondary works, and written evidence) going back to the 14th century (Table 1) to construct Global and Safe Asset Series.

The global series was constructed by weighting all the available advanced economy long-term debt yields (Figure 1) by their share in global GDP.

Table 1: Examples of  Incorporated Personal / Non-marketable Sovereign Loans, (1338-1803)

Source: Page 11 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Figure 1: GDP Weights, and Share of Total Advanced Economy Real GDP Covered, “Global Assets”

Source: Page 4 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

A safe asset series was constructed to proxy the ongoing global risk-free rate of that time. It also provided robustness check for the Global series as both measured (in different ways) the evolution of real rates from 1311 on a global scale.  The safe asset series consisted of single sovereign bonds that offered the best commitment mechanism and financial security (remained risk and default-free) in their respective eras. These bonds can be thought of as the equivalent of the US 10-Year Treasury (safe haven) of that time. Thus, they used individual sovereign rates in the Italian states in the 14th and 15th centuries as a starting point followed later by Spain, Holland, UK, Germany and then currently the US. All of these countries were also respected financial centers of their time as a result allowed one to trace the evolution of the global risk-free rate in an objective manner.

The Result: Multi-century Downward Trend in Global Real Rates

Figure 2: Global Real Rate Series

Source: Page 14 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Figure 3: Figure Safe Asset Series (Single Issuer) and Rates Composition by Century

Source: Page 20 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

A Brief Commentary on How the Real Rates Evolved

Global real rates (figure 2) have trended downwards (from double-digit rates in 14th century) with a fall of 1.75bps on average annually since 1317. There is an occasional reversal in this trend (spikes in real rates) but mostly during a time of either political or economic turmoil. For example, Bullion Famine, Napoleonic Wars, the US civil war, Great Depression and Oil shock (Paul Volcker’s ‘war on inflation). Global safe assets series exhibited a similar pattern as shown in Figure 3 (also making the earlier result robust). The real rate averaged over 9% in the 15th century, declined to 6% in the following century, and averages 1.36% since 2000.

Frequency of Negative Real Interest Rate has Increased Over Time

Through a simple linear trend, the study finds that the share of Developed Market (DM) GDP experiencing negative long-term real rates on average has risen by 1.5 basis points per annum. This trend towards a higher frequency of negative rates real is independent of the establishment of central banks or any dominant currency form (gold, silver, or fiat) as it has been trending upwards since the 14th century. Interestingly, out of a total of 46 annual instances of a negative real rate, 29 instances (63%) of all negative real rate observations have occurred in the 20th century (relative to only four in the 19th century) implying more prominence in recent time.

Figure 4: Average Share of DM GDP with Negative Long-Term Real Rates

Source: Page 45 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Did a Global Bull Run in the Bond Market Start in 1985 as Commonly Believed?

In short – no. The researcher shows that the acceleration in the contraction of real rates (bond price rallies as they have an inverse relationship to interest rates) in the last 30 years is not unprecedented. In fact, this period is comparable to what followed the Napoleonic wars – which saw a period of deleveraging and price stability (similar to the current global economic backdrop). This, in turn, reduced real rates by about 22 basis points annually between 1817-1854.

Figure 5: Real Rate Trend, Safe Asset Provider, and the Six Real Rate Depressions, 1317-2018

Source: Page 51 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Real Rates Have Become Less Volatile and Stickier Over Time

Figure 6: Real Rate Standard Deviation, Global and Safe Asset Provider Basis, 30-year Centered Average (%), 1330-2018

Source: Page 52 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

The researcher after plotting the standard deviation of the long-term real rate found that in recent years standard deviation of real rates has reached historic lows. Global real rates are not just trending lower – they are also consistently becoming stickier (persisting for a longer period relative to past). This suggests negative real rates could now become a more frequent phenomenon and indeed constitute a new normal in our era.

Decoding the Drivers that can Explain the Fall in Real Rates

Falling Credit Risk

Previous studies have found that declining credit risk premia (borrower fails to make the payment) explain the suppression of real rates. In this study, this was not the case. They found that spread (between higher risk long-term sovereign yields and the safe long-term assets) slopes were flatter than those for the real rate fall ( 1.75bps vs 0.88bps) – which means that falling risk premia do not sufficiently explain the trend fall in real rates.

Figure 7: Two Approximations of the Risk Premium Over Time, 1317-1984

Source: Page 29 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Geopolitics

Geopolitical escalations (proxied by Battle deaths per million European population) reveal that escalations like war (proxied by more deaths) reverses the existing trends in the shorter and medium term. The early modern era (highlighted in red) did not witness major geopolitical upheaval and the general interest rate kept on falling. Therefore, Geopolitics de-escalation could be a potential culprit.However, the real rate trend had a downwards drift (regardless of the intensity of geopolitical event)  indicative of other underlying factor/s at play.

Figure 8

Source: Page 36 of “Eight Centuries of Global Real Interest Rates, R-G, and the ‘Suprasecular’ Decline, 1311–2018“

Capital Accumulation (Savings)

The researcher believes capital accumulation could be a potential channel that has driven the real rate trend – as over time precautionary saving rates has risen. Additionally, it could be that geopolitical escalation lowers saving rates ( as a result increases real rates) as saving is used to replenish destroyed physical capital stock. Hence, in the modern era real rates have declined due to the absence of major geopolitical escalation (i.e. WWII) in turn prompting capital accumulation.

Demographics (Population growth) and Real GDP growth

This study further finds that both these drivers provided inconsistent patterns and lower correlations (-0.35 and -0.37 respectively) in explaining the trend of real rates satisfactorily.

Limitations of this Study

• Historically, public finance depended not only on cash transactions but on in-kind transactions (non-money assets like raw food: chicken, fruit or grains repayment in chicken, fruit or grains). Excluding them from total financing costs – could have biased the country-level aggregations done in this study.

• Survivorship bias – those bonds that did not default could be the ones whose data was available and in turn, they also exhibited a lower real rate (due to lower credit risk premia), hence the global series constructed (figure 1) exhibited a biased lower real rates

• The researcher was not sure “which” factor was specifically causing the real rate to decline ( just disproved factors and explained a potential (capital accumulation) channel from the existing literature)

• Missing data were linearly interpolated. Statistically, structural changes are prone to involve nonlinearities

Bottom Line

The secular stagnation theory is questionable against this study. Real rates have fallen recently but this study finds that it has been falling continuously for centuries (not just last 30 years). Recent years of lower real rates merely saw a trend-return and are not unusual. Based on this study, in the future –negative rates could deepen further (continuation of a historic trend) and become a normal part of our financial system. Some experts in agreement with this thesis – believe few advanced economies (like the US and Japan) may actually never hike rates again (Check out our podcast summary Juliette Declercq: Inflations Is Not In The Cards). Nonetheless, based on the findings of this study geopolitical and economic shocks– have in the past ‘broke’ this trend – in effect leading to higher rates. Take a look at our piece on 10 grey swans for 2020; these factors can potentially alter the global real rate trend in 2020.

Mehdi is a research analyst at Macro Hive. He’s currently pursuing an MSc in Finance & Investment at Nottingham University Business School and he is a CFA level 3 candidate. Mehdi has previously pursued roles as an Equity Research Analyst, Junior Economist & in Proprietary Trading.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)