Are Central Bankers About to Lose Control?

Investors are elated by a booming global economy and the promise of central banks to tighten monetary policy only gradually. But a question haunts them: Will interest rates develop a mind of their own?

While central banks set short-term rates -- the 1.5% rate that the Federal Reserve publishes on its website -- economists disagree about how much control they have over long-term borrowing costs. These are gauged by government-bond yields, especially those with returns tied to inflation.

Low inflation-indexed -- or "real" -- rates push money into risky assets, because investors get little extra purchasing power for holding safer securities. According to a new report by BlackRock Inc., the world's biggest asset manager, subdued real rates have been 2017's main driver of returns in global infrastructure debt and investment-grade corporate debt. They also boost gold and real estate, analysts say, which don't pay coupons but don't lose value when inflation rises.

Many markets could climb off record highs if real rates rise. But it is hard to forecast, said Kevin Gardiner, global investment strategist at Rothschild Wealth Management, because "nobody knows exactly what sets interest rates."

Real rates have often moved in lockstep with central-bank policy -- but not always. In the 1970s, runaway inflation pushed real rates down even as the Fed and other central banks increased nominal rates.

Yields on 10-year inflation-linked Treasurys are currently below 0.5%. Before the 2008 financial crisis, they hovered at around 2%. After the Fed unleashed unseen amounts of monetary stimulus, they hit a record-low of minus 0.87% in 2013. Many analysts and investors see it as a sign that policy makers have strong control over real rates.

"We are overweight global indexed bonds," said Paul Rayner, head of government bonds at Royal London Asset Management. "We've done a lot of analysis on this, and ultimately the biggest driver of government bond yields still remains central bank activity, even for [inflation-linked bonds]."

But classic economic theory says that central banks can only influence rates at first, as people ultimately see through their meddling. So unless officials set policy to reflect the economy's long-term economic trends -- which is how the Fed's Janet Yellen and Mark Carney at the Bank of England have justified keeping rates low in recent years -- inflation or deflation will follow.

According to this view, rates are so low because people are saving a lot and these saved funds can be lent out and used to invest, a copious supply that pulls down the cost of borrowing.

Some money managers and analysts now warn that the tide is about to shift, whether central banks keep policy easy or not. By looking at the share of the population aged between 35 and 64 -- when people save the most -- research firm Gavekal predicts real rates will soon rise as people retire and spend their life savings, eroding gains in stock markets.

It "could happen tomorrow or 10 years from now, but I'm not counting on the latter," said Gavekal analyst Will Denyer.

J.P. Morgan Asset Management argues that aging is already starting to push rates higher, meaning that 10-year real yields will be 0.75 percentage point higher over the next 10 years.

Other investors have a different worry: They fear that yields will stay low even if central banks try to tighten policy because they are concerned a recession may be coming. This year, the Fed has nudged up rates three times and yields on long-term government bonds -- both nominal and inflation-linked debt -- have stayed unchanged or declined, echoing similar issues that then Fed Chairman Alan Greenspan had in 2005.

Indeed, the yield curve -- the yield gap between short and long-term Treasurys -- is now at its flattest since 2007, and many investors underscore that, in the past, this has often preceded an economic slowdown in the U.S.

"Unless the evidence is very compelling that's a false signal, I think the market's going to be nervous," said David Riley, head of credit strategy at BlueBay Asset Management, who is now investing more cautiously.

Still, investors may read too much into what yields say about the economy, said the Bank for International Settlements, a consortium of central banks. In new research looking at 18 countries since 1870, the BIS found no clear link between rates and factors like demographics and productivity -- it is mostly central-bank policy that matters.

Does this mean investors can rest easy because rates won't creep up on them? Not so fast, said Claudio Borio, head of the monetary and economic department at the BIS, because officials may still raise them to contain market optimism. Central banks in Canada, Sweden, Norway and Thailand are thinking along these lines, analysts said.

If central banks control real rates, then it is inflation that has a life of its own -- it isn't just a reaction to officials deviating from economic trends -- and it could explain why central bankers have failed to stoke it for years. So officials might as well raise rates to quash bubbles instead of "fine-tuning inflation so much," Mr. Borio said.

Still, Isabelle Mateos y Lago, global macro strategist at BlackRock Investment Institute, thinks investors don't have to worry about this yet.

"The conversation is moving this way, but I don't think central bankers have a fully articulated view," she said.

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

December 26, 2017 08:02 ET (13:02 GMT)