Long-term interest rates overrated as signposts for future growth, inflation: Hyun Song Shin
3 March 2017
Very low yields on long-term government bonds may not necessarily signal prolonged future economic stagnation and deflation but instead reflect efforts by institutional investors to limit risk, Bank for International Settlements Economic Adviser and Head of Research Hyun Song Shin said on Friday.
Research by BIS economists suggests that as monetary easing pushed interest rates to record lows, strong demand for long-dated bonds from insurers and pension funds may have put more downward pressure on yields, potentially creating a vicious circle.
The findings hold lessons for economic commentators and central banks, who closely monitor market indicators such as long-term bond yields - which move in the opposite direction to prices - for signals about the future direction of inflation and economic growth.
"Long-dated yields may be overrated as signals of what will happen in the distant future, especially during turning points in the rates cycle, when such guidance would be most valuable," Mr Shin told the US Monetary Policy Forum in New York.
"If monetary policy responds to lower market-implied inflation rates with further easing, it could add to the feedback loop created by long-term investors chasing yield."
BIS economists analysed portfolio holdings of German insurers, part of the €7.3 trillion in assets held by euro area insurance companies, which serve as the primary means of saving for retirement in many European countries. Life insurance companies and pension funds typically have obligations to policyholders and beneficiaries that are spread over a longer time horizon than the fixed income assets they hold.
Trying to reduce the so-called duration gap requires investors to add more long-dated assets when rates fall, resulting in yield-chasing behaviour. As rates fall, demand increases, driving a feedback loop that pushes prices higher and yields even lower, the analysis shows.
Comparing the German insurance sector's holdings of government bond holdings shows a rise in holdings of long-dated bonds, and a move away from holdings of shorter-maturity bonds.
The researchers identified a similar dynamic at work in derivative contracts used for duration matching, suggesting risk management by long-term investors may also have put upward pressure on the price of options on interest rate swaps, or "swaptions".
During 2014, the long end of the euro swap curve fell by more than 150 basis points while implied volatility in swaptions rose steeply, pushing up the cost of hedging.