The Decade Ahead
Are higher debt and higher rates the new normal?
Key questions
Debt is likely to continue to rise, fixed income volatility is likely to be higher in the decade ahead, and we think it unlikely that rates and yields will return to pandemic-era lows. But we do not believe that rates or yields are now in a structural uptrend. Debt, demographic, and productivity trends, along with a gradual restoration of central bank credibility, mean we expect rates and yields to settle at lower levels than today’s.
Higher debt is the new normal
Higher debt is the new normal
US public finances have deteriorated sharply since the global financial crisis. As a proportion of nominal GDP, public debt has doubled over that time period and now exceeds USD 33 trillion.
The good news is that the US government debt-to-GDP ratio has been declining since the peak COVID-stimulus level of 134% in mid-2020; currently, the ratio is below 120%. But debt concerns are a clear issue for the decade ahead.
Despite a jobless rate at historically low levels, the budget deficit is still large at around 6.3% of GDP, suggesting that the problem is structural rather than cyclical. The Congressional Budget Office’s most recent long-term projections estimate that outlays for interest payments alone could increase from 2.5% of GDP in 2023 to 6.7% by 2053.
The issue is not just a US one; other countries including France and Italy also have persistent structural deficits and high debt loads and will therefore likely face recurring scrutiny by rating agencies and bond markets. Though some countries, like Germany, have been historically more willing to undertake fiscal reforms, significant spending cuts are unlikely in most others. Austerity policies used in Europe in the last decade proved unpopular with voters, and the necessary cohesion is difficult to envisage in the current dysfunctional US political situation.
Central banks are likely to keep yields under control
Central banks are likely to keep yields under control
With fiscal decision-making stymied, we expect monetary policy to assume the role of setting the conditions that would keep government debt servicing costs manageable. Central banks, under pressure from governments, may become more tolerant of above-target inflation, which helps reduce the real value of debt. A return to central bank bond-buying programs to rein in yields is also likely.
Japan’s yield-curve control policy is an example of how this can work. The world’s most indebted developed country has managed to keep the yields on its government bonds close to zero even as government bond yields around the world were rising. The cost, in Japan’s case, has been currency devaluation and imported inflation.
Japan has managed to keep yields low
Change in 10-year government bond yields since respective 2020 low, in bps
- 0 bps
US
- 0 bps
Eurozone
- 0 bps
Japan
Source: Bloomberg, UBS, as of November 2023
We expect rates to settle at lower levels
We expect rates to settle at lower levels
Given out belief that central banks are likely to step in to manage government borrowing costs over the long term, we do not think higher government debt levels will contribute to higher yields.
However, to understand the question of whether higher yields are nonetheless a new normal, we need consider long-term bond yields’ three component parts: inflation expectations, real neutral policy rate expectations, and the term premium.
Inflation expectations. When we consider inflation over longer time periods, the central banks’ 2% targets are an important input, but we also have to acknowledge the implicit asymmetry in inflation targeting: Central banks might allow a period of above-target inflation to compensate for a period of deflation, but they are unlikely to pursue deflation to compensate for a period of high inflation. Political pressure on central banks to ease policy may also increase over time. With this in mind, we believe long-term inflation expectations should sit close to, but above, the 2% target. Our target range for long-term US inflation is 2–2.5%.
Real neutral policy rates. The real neutral policy rate (r-star, or r*)—the rate at which policy is neither restrictive nor accommodative—can be thought of as an average real interest rate over long time frames. The level of r* is not directly observable, but it is generally considered to have fallen since 2008 amid rising debt levels, population aging, and weak productivity growth.
Looking ahead, investments in reshoring, supply chain security, and the energy transition are working to increase r*. But in our view these trends are not as significant as the debt, demographic, and productivity trends that are weighing it down. We therefore believe the r* in the US is little changed in recent years. The Fed estimates it to be around 0.5%. We use a range of 0.5–1%.
Term premium. A final component measures the extra yield investors demand for holding a long-dated bond rather than a shorter-dated one. Historically, investors have typically demanded compensation for holding debt with a longer time to maturity. But over much of the past decade, the term premium has been close to zero, or even negative, in part due to quantitative easing.
In the past year, the Fed’s shift from quantitative easing to quantitative tightening, along with heightened Treasury issuance, has seen investors demand more compensation for holding long-term bonds. But given our view that central banks will continue to step in to prevent any destabilizing increase in yields over the longer term, we do not think the US term premium should trade back to the 1–3% level observed in the 25 years prior to the global financial crisis. We use an estimate of 0.5%.
Adding these three components together, we get a range for the nominal neutral rate (inflation expectations plus r*) of 2.5–3.5%, which, adding the term premium, gives us a central estimate for the equilibrium 10-year US Treasury yield of 3.5%.
|
| 1997–2007 | 1997–2007 | 2010–2020 | 2010–2020 | Our estimates for the decade ahead | Our estimates for the decade ahead | |
|---|---|---|---|---|---|---|---|---|
| Inflation expectations | Inflation expectations | 1997–2007 | 2–2.5% | 2010–2020 | 1.5–2.5% | Our estimates for the decade ahead | 2–2.5% |
| r* | r* | 1997–2007 | c. 1% | 2010–2020 | c. 0.5% | Our estimates for the decade ahead | 0.5–1% |
| Term premium | Term premium | 1997–2007 | 1–3% | 2010–2020 | <0% | Our estimates for the decade ahead | 0.5% |
| 10-year bond yields | 10-year bond yields | 1997–2007 | 4–7% | 2010–2020 | 1.5–3% | Our estimates for the decade ahead | 3–4% |
Investment implications
Investment implications
Our view that the current period of high rates and yields will ultimately prove temporary suggests that investors should focus on opportunities to lock-in yields in quality bonds today.
We also think that higher debt levels, a greater willingness among policymakers to allow inflation to run higher periodically, and uncertainty about the extent to which policymakers might intervene in markets will mean that fixed income volatility and dispersion may be higher in the next 10 years. This should favor active management by both traditional and alternative assetmanagers.
If central banks try to suppress real yields to manage rising government debt burdens through policies such as quantitative easing, it would be supportive of real assets including gold, TIPS, and infrastructure.
More key questions
Other chapters
Other chapters
This report has been prepared by UBS AG, UBS AG London Branch, UBS Switzerland AG, UBS Financial Services Inc. (UBS FS), UBS AG Singapore Branch, UBS AG Hong Kong Branch, and UBS SuMi TRUST Wealth Management Co., Ltd..
