| "The outlook for real estate is good. Negative real interest rates will further stimulate the search for yield, pushing core and secondary cap rates down."
Richard Barkham, Ph.D., Global Chief Economist, CBRE
Last week, the Swiss government sold 378 million francs (approximately US$387 million) of long-term (10-year) debt with a negative coupon of 0.055%. Purchasers of these bonds, who are lending money to the Swiss government, will have to pay 0.055 cents per franc every 12 months for the privilege of doing so.
These are not the first negative interest rates to appear in Europe. The European Central Bank (ECB) has been charging commercial banks for depositing cash in an attempt to boost lending since June 2014. German and Swiss bonds of shorter duration (five years), but with a positive coupon, have had negative effective yields due to market pricing since the start of the year.
Why would anyone pay for the opportunity to lend money? In the Swiss case, there are a number of explanations. 1 For domestic investors, facing the central bank’s overnight deposit rate of negative 0.765%, it provides the opportunity to lose less money than holding cash. For overseas investors, there is the possibility that the Swiss franc will rise further and that they can make a positive return on the currency, or that the spill-over from the ECB’s quantitative easing (QE) program will drive bond rates even lower and prices higher. As Lombard Street Research has recently pointed out, the ECB is committed to purchasing €900 billion by 2016 at a time when the stock of Eurozone government debt is growing more slowly. 2 Figure 1 shows that the cyclically adjusted fiscal deficit of the Eurozone has shrunk in recent years, reducing the need for new government debt issues.
Negative interest rates in Europe reflect a powerful monetary stimulus, deployed by the dominant central bank (the ECB) to prevent deflation, in a period of fiscal contraction. This fiscal contraction is, in itself, partly to blame for the drift into disinflation (the precursor to outright falling prices), which suggests that ultra-low interest rates will be with us for some time. We think this will last for at least two years, even though we are of the view that the deflation story has been overstated and that core Eurozone prices will pick up in 2015.
Our perspective is derived from a longer-term analysis of interest rates in the G7 countries (U.S., Canada, Japan, U.K., France, Germany and Italy). Figure 2 shows that nominal interest rates for the G7 countries have been falling for 30 years, mainly due to the decline in inflation over the period. Many economists attribute this to inflation targeting by central banks, but it is becoming clear that the drift of production to low-cost locations, such as China in the 1990s, has also been important.
Just as significant, and less well recognized, is the fall in real interest rates over the last 30 years (Figure 3). Real interest rates are nominal rates less expected inflation and are determined, in theory, by the balance of savings and investment. 3 Where the opportunities for productive investment are low, relative to the supply of capital from savings, real interest rates will fall as money finds its way into banks and interest-bearing securities.
The fall in real interest rates is not very well understood, particularly the 1980s. Over the whole period there seems to have been a fall in the price of investment goods. As a result it has become cheaper and cheaper to add to the stock of productive capital. On the savings side, in the 1990s, many governments in the OECD improved their fiscal position and ran near balanced budgets (we need to remember that savings can be generated by governments, companies as well as households).
Since 2000, however, the world's “supply of savings” has been boosted considerably by a number of factors. In East Asia, following the Asian Financial Crisis in 1997-1998, countries began to build up “war chests” of foreign reserves as a buffer against potential capital outflows. High savings in many oil-producing countries have arisen from periods of high oil prices. In the case of China, as Chinese households have become wealthier, they have saved more in absolute and relative terms. 4 A high savings rate means that high exports have not been balanced by high imports. So, China has accumulated foreign currency and reinvested this in western bond markets, depressing interest rates. Although China has set itself the task of reversing this situation, reducing savings and boosting domestic demand, it will take at least five years to achieve this.
More recently, “excess savings” have been generated by some export-orientated countries in the Eurozone, Germany in particular. Overall, the world is awash with savings. Negative interest rates in Switzerland are very newsworthy, but they are part of a very long-term trend that looks set to continue for some time, at least five years in our view.
So, what does this all mean for real estate? If we are correct that fears of Eurozone deflation are overblown, the economy is already reviving and negative interest rates reflect the juxtaposition of massive QE and a limited new supply of government debt, then the outlook for real estate is good. Negative real interest rates will further stimulate the search for yield, pushing core and secondary cap rates down. There is a possible downside in the U.S. as capital flows push the dollar up and hit U.S. corporate earnings, but at least arbitrage will continue to keep the U.S. long bond (10-year Treasury) at around 2%.
More broadly, the “re-rating” of world real estate that took place around 2004 looks set to continue for at least two years—and probably longer. Our analysis suggests that the long-run average, around which yields fluctuate, dropped by about 100 basis points at that time and a further decline in the equilibrium long-term yield is entirely possible due to the persistence of the “savings glut” in the world economy. Negative interest rates maybe a relatively short-term phenomenon, but very low interest rates will be with us for some time.
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1. In general, with stable prices, bonds are a convenient way of storing large amounts of cash, with a small negative interest rate broadly analogous to bank charges.
2. Lombard Street Research, Macro Picture, ‘Underworld’, April 9th, 2015.
3. At the long end of the market, there is an intrinsic link between real and nominal rates. Where the real return is rendered uncertain due to the volatility of inflation, a real risk premium will be required.
4. IMF, World Economic Outlook, April 2014, Chapter 3. |
