The Forces Behind Negative Real Interest Rates

Of all the issues that economists have struggled to understand over the past few years, there's one that's particularly perplexing: While the fiscal health of the United States and Japan continues to deteriorate, evidenced by record fiscal deficits and debt-to-GDP ratios, both countries' bond yields have gone down and not up as common sense would seem to dictate. In the United States, in fact, the real rate of return on almost all federal government bonds is negative.

The standard explanation is that, since the economic downturn, the Federal Reserve has flooded the economy with cheap credit, and investors have preferred government bonds over equities and other corporate securities because the latter exposes their principal to risk of loss. The problem with this explanation, however, is that it's incomplete. Namely, the downward trend in government yields is by no means a recent phenomenon. As my colleague noted a few months ago, it's been ongoing for more than 30 years now.

The supply and demand of money
To understand why interest rates are so low, it's helpful to think of money as a commodity and interest rates as its price. Take corn as an example. On Friday, it was reported that the upcoming corn crop will be the largest in 75 years. What do you suppose will happen to its price? Assuming demand stays constant, of course, it'll go down.

Well, the same rules apply to money. Namely, its price is a function of supply and demand. On the one hand, an increase in the supply of money or a decrease in its demand will make money cheaper, and therefore drive interest rates down. And on the other, a decrease in the supply of money or an increase in its demand will make money dearer, and therefore drive interest rates up. For the economically inclined, this is the essence of monetary policy.

Supply and the "global savings glut"
At this point, if you'd guessed that the supply of money must have increased, you'd be exactly right -- though you may have misidentified the main culprit.

In 2005, the now-chairman of the Federal Reserve, Ben Bernanke, delivered a speech taking issue with the conventional view that the deterioration in the U.S. current account -- a measure of the trade deficit -- primarily reflects economic policies and other developments within the United States itself. The true cause, according to Bernanke, was what he called the "global savings glut." To be more specific, he argued that a combination of forces (namely, growth in the emerging markets such as China and an upward trend in oil prices) had created a significant increase in the global supply of savings in places such as Asia and the oil-producing countries.

While Bernanke's speech focused on trade imbalances, his savings glut hypothesis also explains why interest rates have detached from fiscal reality. Here's how. Since 2000, China's foreign currency reserves (a measure of savings at the sovereign level) have gone from $159 billion to $3.2 trillion, Saudi Arabia's have gone from $16 billion to $540 billion, and Russia's have gone from $9 billion to $462 billion. Meanwhile, over the same time period, China's demand for U.S. Treasuries has gone from $60 billion to more than $1.1 trillion. And when you take all of the oil-exporting nations together, their holdings of U.S. debt have gone from $48 billion to $259 billion.

Thus, to circle back around to the laws of supply and demand, there's been an enormous increase in the supply of money flooding into the United States. And as one would expect, thinking again in terms of interest rates, this has driven the price of money down.

Demand and the "missing market"
Now, if you've followed along this far, you may be wondering what's happened on the demand side of the equation, as an increase here would offset the downward pressure on interest rates. And it turns out the answer is: not much. The reason is what economist call a "missing market."

A missing market is a market failure that occurs when a competitive marketplace allowing for the exchange of a commodity -- be it a good, service, or whatever -- simply doesn't exist. Take pollution for instance. Prior to the introduction of environmental regulations, a factory that discharged pollution into the air or a nearby river typically wasn't responsible for all of the accompanying costs. That all changed, however, with the introduction of the cap-and-trade market, the system under which polluters can essentially exchange among themselves the right to pollute.

In the financial and monetary sphere, the problem lies in the undercapacity of credit markets -- for our purposes, think of government borrowing via bonds as the demand for money. Although new sources of money supply have come on line over the past few decades, no new sufficiently deep and liquid bond markets have come along as well -- thus, the missing market problem. Since World War II, the only two bond markets of note have been the United States and Japan. And while China is trying to get a complementary market up and going, called the Dim Sum market, it's still in its infancy -- a mere $29 billion in Dim Sum bonds were traded on the exchange last year, compared to America's $36 trillion market.

The future of interest rates
To summarize, one of the principal reasons real interest rates are so low, even negative in many instances, is because of a mismatch between supply and demand for money. The growing supply of funds from the emerging markets such as China and the oil-producing countries has simply overwhelmed the capacity of established bond markets. Consequently, if the above analysis is any indication, interest rates are bound to stay low for at least the foreseeable future -- that is, until other sources of demand like the Dim Sum market mature and/or come on line.

This is great news for companies such as Annaly Capital Management (NYS: NLY) and Chimera Investments (NYS: CIM) , both of which borrow money at cheap short-term interest rates and reinvest it at higher long-term rates, pocketing the difference. And it's also great for prospective homeowners, as the prime rate is lower than it's ever been. Whether this will result in a new lease on life for builders such as Hovnanian Enterprises (NYS: HOV) or PulteGroup (NYS: PHM) , the former of which is in the process of raising new capital, remains to be seen. But it at least gives them a fighting chance.

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At the time thisarticle was published Fool contributor John Maxfield does not have a financial position in any of the companies mentioned above. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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