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Economic Forecasts

Why Yields Stay Low

Three powerful economic forces are very hard at work, pushing interest rates downward.

Energy prices soar, commodities hit all-time highs, gold climbs and governments (our own, in particular) churn out hundreds of billions of dollars of new debt. Yet long-term interest rates remain remarkably low. The ten-year U.S. Treasury bond yields about 4.5%. Interest rates in Europe, at 3.5%, are even lower. What is going on here? Yes, inflation is way down, due to the flood of cheap goods from China, India and other developing countries. But this cannot be the whole reason. Even when you strip away inflation, interest rates are extraordinarily low.

Powerful forces

Three powerful economic forces are very hard at work, pushing interest rates downward. The first is the extremely high level of worldwide saving. Asia is the biggest player, with China, Japan and Taiwan holding more than $1 trillion of U.S. debt last year. In fact, despite the huge increase in government bonds over the past 15 years, the absolute amount of government debt held by U.S. private investors has actually declined.

The second force is the aging of the developed world's population. As people get older, their portfolios become more conservative and tilt toward bonds. Companies are encouraged to fund their pension liabilities with bonds instead of stocks. As a result, bonds are becoming popular with pension trustees worried about penalties associated with underfunding -- a risk that is higher with stocks. Funding of pension liabilities with bonds is already popular in Europe.

Far less recognized for holding down interest rates is reduced capital spending. You'd expect that a drop in the real cost of borrowing would cause firms to increase investment spending. And, yes, the boom in the housing sector is due in large part to the drop in real interest rates. But outside of that, inflation-adjusted fixed investment fell by almost 50% between 2000 and 2004 and picked up only a bit last year.

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Behind this decline is the tremendous drop in the cost of not just technology, but also machinery and other capital expenditures. The decline in inflation-adjusted yields began just after the turn of the century, when Y2K spending peaked. Since then, many organizations have found that spending needed to upgrade and replace technical equipment has fallen. For example, ten years ago, my university department's annual research budget paid for one juiced-up personal computer. Now it more than covers a desktop and a laptop, leaving us money left over.

What does all this mean? The demand for bonds has been enhanced by purchases from Asian central banks and other organizations funding their pension liabilities. Yet the supply of bonds has been limited by the sharp drop in funding for capital spending. Together, these two trends have caused bond prices to rise and yields to fall.

The critical question is how long this state of affairs will last. Savers in the developed world are not getting younger, so the demand for bonds will continue to rise from this source. And the funding of pension liabilities by bonds may accelerate as the government limits the degree that pensions may be underfunded.

Next move: Up

But the demand for capital will certainly increase. Developing countries have massive spending requirements ahead of them that will sop up some of the worldwide savings glut and send interest rates higher. And as the developing countries become richer, their preference for stocks over bonds from the aging developed countries will be reflected in interest rates.

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I don't know how long low interest rates will prevail, and we may never know the whole story of why current rates are so low. But if history is a guide, take advantage of these rates while you can -- the next move is upward.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.