Leave it to the current generation of central bankers with their abundance of God complexes to believe that they can shape anything but the very shortest end of the yield curve.
While they set overnight interest rates and the nominal supply of money by brazen open-market purchases of securities inflating their balance sheets, ultimately interest rates – the ones that count further down the yield curve – must always be a function of the real economy.
What is the supply of money from those who are saving and the demand from those who are borrowing?
Borrowing, or the demand for money, is easy to observe and measure as it is simply a function of banks’ loan books. These show that, in the US at least, there has been consistent loan growth since the financial crisis underpinning a slow but steady economic expansion. It is a broadly similar picture in South Africa, where banks expanded their loan balances to businesses and households consistently up to 2020, following which (owing to either worsening credit quality or demand for borrowing) it has flatlined.
Either way, it can be surmised that borrowing is more or less constant. Though it might increase one year more than others, massive fluctuations – the type that would have a major impact on the price of money, the interest rate – are extremely unusual.
The supply side, however, is far more interesting, if complicated. Household savings tend to be fairly consistent over the long term, even if they differ substantially across economies and countries. Much academic research has been done on this topic, but it remains unclear as to exactly what shapes an economy’s predilection to save. For example, over the past 50 years, Americans have consistently spent more and saved less than Chinese, who save an extraordinary 40% of aggregate income.
One exception occurred last year when the Biden administration decided to send yet another round of cheques to every household in America. This had the instantaneous effect of increasing savings, and thus – regardless of anything the Fed happened to do – lowered the price of money.
When forecasting future interest rates, the critical question is: what will determine short-term saving rates? That is almost always largely a function of the cost of energy or, in the shorthand of traders, the oil price. This is simply a factor of the material importance across the economy of energy prices as a share of income spent; estimates vary but indicate that, in the US, about 10% of household incomes is spent on energy, and this increases to around 25% for lower-income households.
In emerging economies such as South Africa, the percentage is equally high at about a quarter of income. The only truly variable cost eating at savings is energy.
This is borne out by data; the long-term correlation between the oil price and the US benchmark 10-year treasury yield (with higher oil prices resulting in higher prices of money or interest rates) is extraordinarily consistent, especially in periods of oil price volatility.
Of course, when it comes to the oil price, we find ourselves in a fascinating if concerning situation. Oil prices hit a seven-year high last week on bets that demand could outstrip supply later this year. Brent, the international benchmark, rose to a high of $88 a barrel, the highest level since October 2014 and almost 30% higher in only two months.
Traders say that the market is caught in a perfect storm of limited capacity for producers to increase supply after years of underinvestment in new projects, a very limited appetite for OPEC+ to lower prices, and a surge in post-pandemic lockdown demand for energy as the northern hemisphere enters the coldest spell of winter.
Spending on renewable energy has not helped as oil majors have prioritised green transformation above increasing the production of fossil fuels. Total spare capacity among Opec+ members was forecast to reach “historically low levels” of about 1.2 million barrels per day by the summer, according to Goldman Sachs, which says that $100 a barrel by the end of the year is entirely feasible.
Therefore the question must be: what impact will this have on the global economy and markets? If oil continues to go up, consuming savings and household incomes, it will pull up yields and exacerbate cost-side inflationary pressures. This would result in higher prices, lower disposable incomes, a slowing economy, rising bond yields and higher interest rates. Quite simply, it could be a worst-case situation for valuations of risk assets such as equities, which are contingent on economic growth and lower discount rates for their valuations.
Net energy-importing developing economies such as South Africa are particularly exposed. It is far too early to say if this toxic mix of inflation, rising energy prices, slowing economic growth and rapidly rising yields will happen. But the reality is that, if yields become stubbornly high because of energy prices, the effects on risk assets such as equities and the economy could be profound.
