A sneak preview of the future of bonds interest rates and inflation

I have one chart for you today, and it gives you a sneak preview into the future: the future of interest rates bonds and inflation.

Article updated: 2 November 2020 1:00pm Author: Michael Baxter

I am a big fan of underlying forces — what are the drivers that shape the economy, bond yields, interest rates and equity prices?  They are connected: the economic conditions help shape bond yields which influence interest rates which affect equity prices. But a surge in equity prices can impact the economy, interest rates and bond yields. They all influence each other.

In theory, equity prices are a function of expected future dividends discounted by projected future interest rates to get a net current value. If you have reason to expect interest rates to be lower in the longer term, then it is not unreasonable to expect equity prices to be higher. However, the factor that leads to lower interest rates may lead to lower dividend yields. So, it is complicated.

That is why I like underlying forces. Drill down and see what it is that shapes these four factors.

There are several underlying forces — one is technology. One is demographics. And there are others of course. I speculate that technology innovation will be rapid over the next two decades, but we don't need to do much speculation when predicting demographics — we have a pretty good idea where that is going.

We know that population growth and the future ratio of young people to older people is a function of the fertility rate 

Look at the fertility rate, and we can get a feel for what the future might look like — just a feeling, we won't know it all, but we will get an idea.

According to a recent report, University of Washington's Institute for Health Metrics and Evaluation, no less than 23 countries are expected to see their populations halve by 2100.  This is a big deal. You often read that population growth is out of control, and as a result, we are on a one way route to destruction, but the same report projects that the global population will peak around 2067. The report predicts that the global population will increase by a quarter between now and then, but by the year 2100, the global population will be 8.8 billion and falling, compared with 7.8 billion today.

Of course, it also depends on the death rate and average life expectancy, and new technologies may increase life expectancy.

Between 1950 and 1955, the only country in the world with a fertility rate (births per woman) less than two was Luxembourg.

In 2014, 83 countries had a fertility rate less than two and 55 had a fertility rate of between two and three. To put that in context, in 1970, only 46 countries in total had a fertility rate less than three, and only four less than two. In 1970, 34 countries had a fertility rate over seven, in 2014 just two did (Niger and South Sudan.)

In 2014, India's fertility rate was 2.4, and China's was 1.6. Every G7 country has a fertility rate of less than two. Among countries with a fertility rate of less than 1.5 are Japan, Italy, Germany, Spain, South Korea and Taiwan. 

I can't emphasise enough how significant all of this is. The ageing of the global population will lead to a rapid increase in demand for healthcare and automation technologies as the shrinking pool of workers has to provide for a growing pool of retired people.

And of course, the retirement age will go up and up. I think people entering the workforce today will work until well into their 70s maybe even approaching 80.

And what does all this mean?

Take this chart, provided with permission of David Beckworth, research fellow in the Program on Monetary Policy at the Mercatus Center of George Mason University.


The correlation between population growth rate and real ten-year yield is clear.

If you want to know what the real ten-year yield will be in the future look at the projected population growth rate.

Okay, real ten-year yield is not the same thing as yield — real-yield takes into account inflation.

But we only need to look at Japan to see how low population growth and low inflation are linked. Besides, presumably, if real yields are low, implicit to this is the assumption of low inflation.

So, what do I conclude?

Real bond yields will continue to fall for decades. Interest rates will remain low indefinitely, and inflation will be weak.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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