CIO Special - Financial repression: still restraining real rates Policy sustainability and the investment response
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April 2021 CIO Special Financial repression: still restraining real rates Policy sustainability and the investment response
CIO Special
Financial repression:
still restraining real rates
Contents
Authors:
01 Introduction p.2
Christian Nolting
Global Chief Investment
02
Officer
Gerit Heinz Financial repression: a history p.4
Global Chief Investment
Strategist
Stefan Köhling
Investment Strategist
Europe
03 Policy sustainability and risks p.10
Gabriel Selby, CFA®
Investment Strategist
Americas 04 Possible future scenarios p.13
05 What this means for investors p.15
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CIO Special
Financial repression:
still restraining real rates
01 Introduction
Christian Nolting GDP growth will return to positive territory in 2021. Reflationary policies in response to the
Global Chief Investment devastating economic impact of the coronavirus have already led markets to anticipate some pick
Officer up inflation and, in many economies, yields have risen.
No-one, however, expects a quick return of interest rates to their levels of a few decades ago.
In a historical context interest rates are still at extremely low levels and major central banks
have indicated that they will be tolerant with regards to inflation and keep rates low. “Financial
repression” – the use of policy to keep real interest rates very low or negative – is here to stay.
In some ways, it is surprising that “financial repression” is not more controversial. Low interest
rates lower the cost of borrowing but, conversely, may also make it more difficult to reach
investment goals. They affect debt levels and asset prices. This is an issue of great importance to
all investors.
The main reason for general acceptance of “financial repression” is that we have probably just
grown too used to it.
“Financial repression” long predates the 2020 pandemic: like some other policy issues,
coronavirus has simply accelerated an existing underlying trend. It first came to prominence
earlier at the start of the global financial crisis (GFC) in 2007-2008, when many central banks
deployed financial repression (in the form of lower policy rates and quantitative easing) as an
essentially tactical tool to try and kick start economies. Yields on government bonds been falling
for a decade or more, when adjusted for inflation, as shown by Figure 1. They have also been
falling in nominal terms.
Figure 1: 10-year inflation-indexed government bond yield comparison
Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.
%
2
1
0
-1
-2
2010 2012 2014 2016 2018 2020
U.S. Germany
But financial repression has even deeper structural roots. It is linked, as we discuss, to longer-term
trends in demographics and productivity which will remain relevant, even as the global economy
picks up pace in 2021.
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CIO Special
Financial repression:
still restraining real rates
The tendency for government debt levels to rise has been accelerated by the COVID-19 crisis
while inflation rates have remained subdued. While the former creates a conflict of interest for
central banks, the latter gives leeway to keep interest rates low. Monetary and fiscal policy are
more interlinked than in the past, given the huge amounts of government debt now sitting on
central bank balance sheets.
But is financial repression sustainable, or should we expect some (perhaps involuntary) reversal
of policy? One major concern around financial repression is that it could result in high levels of
inflation. Such fears have not so far been realised and some central banks would in fact welcome a
temporary increase in inflation (with several recently changing their objectives to reflect this). In a
historic context, nominal yields as well as inflation rates remain obstinately low.
But other issues will arise. While financial repression may help to ensure economic stability in
as much as it constrains the cost of government debt servicing, it does not guarantee financial
market stability. Low yields may encourage unexperienced investors to take on more risk than
suitable or encourage highly leveraged positions. Small market moves may result in higher
volatility if leveraged positions need liquidation. This threat of instability is in addition to creeping
devaluation of wealth caused by negative real interest rates. We look at how to deal with this.
Financial repression: history and incentives
o Financial repression long predates the 2020 pandemic. The
coronavirus has simply accelerated an underlying trend.
o Central banks are likely to keep real interest rates low, and
financial repression will continue for the foreseeable future.
o But investors should be aware that a policy designed to promote
economic stability will not guarantee financial market stability.
Past performance is not indicative of future returns. Forecasts are
not a reliable indicator of future performance. Your capital may be
at risk. Readers should refer to disclosures and risk warnings at the
end of this document. Produced in April 2021.
3
CIO Special
Financial repression:
still restraining real rates
02 Financial repression: a history
Financial repression is a policy of keeping interest rates at very low or negative real levels.
Historically, this has not been seen as a positive concept: the originators of the phrase (back in
the early 1970s) were criticising the use of such a policy as a way of obtaining cheap funding for
government debt at the expense of savers.
Financial repression, as this implies, is not just due to the coronavirus pandemic. And, while
the current market focus may now be on inflation threats and rising yields, financial repression
remains in place and will continue to dominate monetary policy for some time to come.
In fact, even nominal interest rates have been falling for decades. Risk-free rates (i.e. U.S. T-Bills)
fell from more than 10% in 1984 to below 0.1% this year. In some other parts of the world,
nominal interest rates on longer-dated government bonds turned negative years ago, reflecting
expectations that short-term interest rates would not increase for the foreseeable future.
The declining natural rate of interest
Various structural forces are pushing down the so-called natural rate of interest (R*) – the rate
which brings an economy’s output in line with its potential. This natural rate (sometimes referred
to as the neutral rate) is not observable in reality but policy makers around the world estimate its
value when they set policy rates – so as to judge whether these rates will stimulate the economy
or rein in output to combat inflationary pressures.
R* is affected by numerous factors and estimates of it differ from region to region. In the United
States, estimates using the Laubach Williams model indicate that R* has fallen to close to zero
over the last decade (Figure 2). Equivalent figures for the Eurozone reveal a similar story.
R* is highly positively correlated to trend GDP growth. Broad shifts in trend growth rates in
developed countries over the past few decades may therefore indicate where interest rates are
likely to go from here. Many explanations for slower trend growth focus on changing working-age
populations, ageing societies and technological progress.
Figure 2: The natural rate of interest (R*) and nominal potential GDP growth in the U.S.
Source: Federal Reserve Bank of New York, Federal Reserve Bank of San Francisco, Deutsche Bank AG. As of
April 9, 2021.
%
16 7
14
6
12
5
10
4
8
3
6
2
4
1
2
0 0
1961 1971 1981 1991 2001 2011 2021
Nominal Potential GDP Growth Rate (LHS) Natural Rate of Interest (RHS)
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Financial repression:
still restraining real rates
The fall in R* has some immediate policy implications: a low R* has meant that central banks have
less room to simply cut policy rates as they approach the so-called "lower bound" in many regions.
(The worry is that if interest rates fall below this theoretical threshold, investors will prefer to hold
physical cash.) Even if we have not yet reached this level in interest rates, central banks have
enhanced their policy toolbox. In a low yield environment, they have introduced unconventional
measures such as quantitative easing or yield curve control to achieve a greater monetary
stimulus effect than with traditional monetary policy instruments. In the past, policy rates stood
very much higher and therefore a sufficient monetary impulse could be provided by lowering
these rates alone. A return to such a situation looks very unlikely for a long time to come.
Central banks use R* in their assessment of the economic situation and then try to adjust the risk
free rate (proxied by government bond yields) to set the right impulse dependent on the economic
cycle. They can partially influence this risk-free rate implicitly via open market operations (e.g. QE)
and explicitly via setting policy rates. R* provides a starting point for such policy calculations.
What this shows is that a seemingly abstract discussion of R* is in fact a contributor to the level
of yields we see in fixed income securities every day. By intervening in the market (e.g. through
bond buying programmes or setting policy rates) security prices are either directly or indirectly
mirroring central bank policy. Rising longer-dated government bond yields could for example be a
sign of an anticipated rate hike (by markets) in the near future while a drastic fall would imply the
opposite.
Demographics: the example of Japan
Japan is often cited as a real-time example of how long-term shrinkage of the working-age
population can translate into a long phase of economic stagnation (which is also closely
correlated, as noted above, to lower interest rates). Rising life expectancy and decreasing fertility
rates without corresponding compensating migration movements have had a remarkable impact
on Japan’s total working-age population (Figure 3). However, Japanese people tend to work even
beyond the official retirement age of 65.
Figure 3: Working-age population (15-64) indexed so that January 1, 2004 = 100
Source: OECD, Deutsche Bank AG. As of April 9, 2021.
120
115
110
105
100
95
90
85
2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Japan Germany U.S. Italy
Technological progress can only partly compensate for this, particularly if an economy is capital
intensive already. The sustained increase in Japan’s median age from 35 in 1985 to over 48 today
has therefore pushed down the economy’s growth path. Gross value added for the whole country
in general has barely increased while its debt burden relative to GDP has risen significantly.
Most of the developed countries in the Eurozone are experiencing similar demographic trends,
with the fertility rates of generations born after 1965 significantly lower than the preceding “baby
boomers”. Migration may mitigate the effects of an ageing society in Europe, however.
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Financial repression:
still restraining real rates
Even China – as a consequence of the one-child-policy introduced in 1980 – will face a phase of
declining population in the coming decades. One study (by the Institute for Health Metrics and
Evaluation, IHME) predicts that the population in China will almost halve from more than 1.4 bn
today to 730 million by 2100. (Other studies show a less severe decline.) Since 2016 couples have
been permitted to have two children, but with a fertility rate of 1.7 the population is still likely to
shrink, as it is the case in many industrialized and emerging countries.
Median population ages vary greatly according to United Nations data, with the U.S. (38.3) and
China (38.4) slightly above the G20 median of 34.4, but Germany (45.7), Italy (47.3) Japan (48.4)
much higher. The latter two also have the highest debt to GDP ratios among developed countries.
With fertility rates in long-term decline, global median ages are likely to rise further, and without
counter-measures (for example around labour market participation) “Japanification” will spread to
other economies. However, trends in working-age populations do vary between countries (Figure
3), with the U.S. managing to increase its working-age population (not least due to immigration)
while the Eurozone’s has remained static and Japan’s has declined.
This will have important implications for policy and thus interest rates. Japanese business cycles
have become shorter and relative debt levels have risen further, as policymakers have not been
able to achieve either growth or inflation to extract the country from its current predicament. The
Japanese economy has also proved more vulnerable to external shocks. However, Japan has also
had some idiosyncratic events such as the Kobe earthquake or the Fukushima tsunami with their
respective impacts on business cycles. Mounting debt levels may limit the ability to counterbal-
ance economic downturns in particular if growth is anaemic for a while due to an ageing society.
Ageing populations also have a major impact on savings behaviour and thus interest rates in
equilibrium. Ageing populations tend to have higher savings rates during the active working life
because they have to save to provide for a longer retirement period than in previous years. There
is an argument that increased savings by “baby boomers” in recent decades have increased
aggregate savings to an extent that cannot be absorbed by higher investing activity – the so-
called “savings glut”. This has pushed down equilibrium rates. A quick end to this imbalance
between savings and investment is not expected – although, in the longer run, a growing elderly
population could push up spending on goods and (labour-intensive) care services from a shrinking
workforce, closing the gap at least partially and possibly finally leading to higher inflation.
But to boost economic activity, growth in the manufacturing sector is also required. Apart from
the labour force, higher investment is one way to encourage higher growth. However, many
other trends would support the argument that investment activity will remain rather weak in the
future. Decreasing labour force growth also means that lower growth in companies’ capital stock
is needed to preserve a given capital-employment ratio. Demographic changes over the last few
decades have also happened against a background of gradually declining public investments in
many developed economies (at least pre-pandemic) partly because of higher debt burden.
Figure 4: Long-term contributors to financial repression
Source: Deutsche Bank AG. As of April 9, 2021. R* is the natural rate of interest.
Savings to
investments imbalance
Ageing
populations
Structural trends Low existing Further stimulus needs
reinforce financial interest rates unconventional policy
repression
Low R*
Lower trend
GDP growth
Quantitative
easing
Low productivity Yield curve
growth control, etc.
Changing economic
structures
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Financial repression:
still restraining real rates
Technology and productivity
The other main contributor to long term growth apart from labour is technological change
(particularly if the labour force working-age population is shrinking as noted above). This is by
its nature difficult to measure, but it is possible to identify some general trends. Economic theory
defines productivity gains as the growth residual which cannot be explained by labour and capital
(so-called total factor productivity).
So in that sense, technological progress in general help us increase productivity and hence
growth and therefore should be one factor pushing up the neutral interest rate (R*). So why is this
not happening?
Shifts in the structure of western economies are an important factor behind productivity
trends in recent decades. The contribution of the often more innovative and capital-intensive
manufacturing sectors to total GDP has been shrinking. Use of capital in the form of technological
progress has led to productivity gains be it via hardware (e.g. robotics) or software (e.g.
processes). The services sector contribution has risen. While productivity gains via technology are
possible (e.g. via software), many traditional services tend to be more labour-intensive and thus
productivity gains may be more difficult to achieve.
Weaker productivity growth may also be linked to the higher market concentration of companies
in some sectors – the emergence of “winner takes it all” firms. Economies of scale from this
process may allow for cost savings, but also result in declining competition (as they lead to
oligopolistic structures) and rising market entry barriers for new firms, perhaps discouraging
innovative approaches.
Finally, the low interest rate environment has allowed some non-profitable companies to survive
because of very low financing costs. This may have hindered the process of “creative destruction”
and thus necessary structural changes in the economy – holding back technological progress.
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Financial repression:
still restraining real rates
Other factors pushing down interest rates
Other possible explanations for the long-term fall in interest rates include a decreasing demand
for capital caused by ongoing digitization, e.g. through a shift from investments in capital
intensive goods towards more intangible goods (i.e. software). Other commentators – for example
the former U.S. Treasury Secretary Larry Summers – have seen the developed economies as
being in a “secular stagnation” phase. They point to a decline in investment opportunities caused
by slowing population growth and a decrease in the rate of technology progress. This leads as a
consequence to a situation with excess supply of savings and lowered aggregate demand.
Wealth and income distribution may also have contributed to lower rates. Growing inequality is
often associated with a lower average propensity to consume as upper income households tend
to save a higher portion of their disposable income, which also contributes to excess savings and
by this lowering equilibrium rates.
Policy responses
In the past, central banks have tried to set the appropriate policy rate by assessing inflationary
pressure in conjunction with the natural rate of interest, the economic slack measured by the
output gap in an economy and the inflation rate. During normal business cycles, government bond
yields fall in the downturn phase, and then rise during the economic recovery phase, anticipating
changes in future monetary policy.
Figure 5: Central banks' total assets
Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.
USD bn
8000
7000
6000
5000
4000
3000
2000
1000
0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
ECB (in EUR) Fed (in USD)
However, the previous correlation between growth rates and interest rates broke down after the
start of the global financial crisis (GFC). Government bond yields (taken as proxies for risk-free
rates) then fell well below the nominal growth rates of western economies. There were several
reasons for this.
In the aftermath of the initial phases of the GFC, private actors started to deleverage, keen to
reduce the high levels of debt that had contributed to the GFC, but adding further to already
extensive economic slack and deflationary pressures. This has helped keep the natural rate of
interest low in the last decade. And just as this economic and labour market slack was being taken
in, the 2020-2021 coronavirus pandemic then dashed hopes of an imminent return to economic
stability.
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Financial repression:
still restraining real rates
Loose monetary policy, once seen as a temporary measure post-GFC, had become normal before
the coronavirus pandemic, despite economic recovery in many parts of the world. Markets and
companies quickly got used to the continuous liquidity injections. Low rates have resulted in a
classic “liquidity trap” whereby individuals/firms have little incentive to lend money for productive
use, preferring instead to keep it as cash balances or invest in financial assets. So while base
money (i.e. cash and central bank deposits) has grown, broader measures of money supply which
are relevant for the transmission channel from monetary growth to inflation have increased only
slowly. The velocity of circulation of money has also decreased. To slightly over-simplify, the new
money has been hoarded. Central banks have struggled to normalize their monetary policy in this
rather undynamic environment, meaning that interest rates have remained lower for longer than in
most other previous business cycles.
2021 and probably the following years too will be characterized by continuous loose monetary
policy perhaps with further central bank asset purchases (Figure 5) and policy rates at their
present or lower levels – a wording the ECB has been using in its policy statements since some
time. Implementing lower or negative nominal interest rates may become easier for central banks
if central bank digital currencies are introduced. Further information on this can be found in our
CIO Special: Central Bank Digital Currencies – Money reinvented.
Low R*: drivers and implications
o Various structural factors are pushing down R*, the natural rate of
interest, which is highly positively correlated to trend GDP growth.
o Demographics, technology and wealth and income distribution are
among factors which may have contributed to a lower R*.
o A low R* encourages non-conventional monetary policy easing
and markets have become accustomed to liquidity injections: they
are no longer simply a tactical measure.
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Financial repression:
still restraining real rates
03 Policy sustainability and risks
Debt growth
Fiscal policy has also played an important policy role. Economic restrictions due to COVID-19 led
to unprecedented levels of fiscal expenditure. State guarantees, direct money transfers to citizens
and furlough schemes have far exceeded in scope the fiscal measures launched in the wake of the
global financial crisis (GFC). Extensive governmental support will not end by this year and will go
beyond 2021, as shown by the European Recovery Fund and the additional fiscal package under
the new Biden administration in the U.S.
As a result, debt has increased sharply, to levels which (pre-pandemic) would not have been
classified as sustainable under traditional valuation methods (for example, the Maastricht criteria
for Eurozone countries subsequently embedded in the stability and growth pact). Elevated
spending does not seem likely to be followed by a period of austerity, given the continuing
ravages from coronavirus.
As a result, the “post-pandemic-age” will be characterized by many countries living with their
highest debt levels in post war history. Debt levels in many industrialized countries have already
surpassed 100% of GDP.
Of course, many economies have temporarily experienced high debt levels before. The question is
how sustainable they are, and how they can be reduced.
One traditional resolution of the debt problem has been to grow your way out of debt – increasing
growth so that the debt/GDP ratio falls. But, as we discuss elsewhere, potential nominal growth
for developed economies has been falling for decades, due to demographic and other factors.
Attempts to get around this through other ways (e.g. structural reforms) are difficult and take time.
Moreover, the extra spending funded by recent debt seems unlikely to give a classical Keynesian
uplift: most of it is replacing income rather than creating extra demand. Falls in demand for many
services during lockdowns also cannot be made up for by higher post-lockdown supply. Full or
partial debt defaults are not an option for countries wanting to preserve easy access to capital
markets.
The IMF assumes that among the largest western economies, only Germany will succeed in
reducing debt significantly. The others (e.g. the U.S., France, Spain or Italy) will continue to have
debt levels well above their annual GDP in 2026.
Figure 6: Debt to GDP rates and IMF medium-term forecasts
Source: IMF, Deutsche Bank AG. As of April 9, 2021.
(%)
300
250
200
150
100
50
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
Italy UK France Japan U.S. Germany Spain
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Financial repression:
still restraining real rates
In the past, inflation (as one component of nominal GDP growth) has offered another way of
reducing debt. At some point, inflation will pick up, particularly in some sectors (e.g. services)
and de-globalisation may play a role in pushing up prices of some goods. Temporary increases
in inflation are also possible due to the pro-cyclical nature of some fiscal measures (i.e. boosting
spending during an ongoing expansion). But dramatic sustained rises in inflation seem unlikely,
given the slack in the labour market, meaning that countries will not find it easy to inflate away
debt.
This puts the debt management focus firmly on financial repression – holding down interest rates.
This can contain debt service (particularly if maturing existing debt can be refinanced at lower
interest rates) but will take a long time to reduce debt.
Figure 7 shows that, even with growth rates being 3% above interest rates – which would imply
quite heavy financial repression – debt levels would fall by less than 30% over a decade.
Figure 7: Government debt reduction scenarios (as % of GDP) with balanced budgets
Source: Deutsche Bank AG. As of April 9, 2021. Note: The x-axis represents years from when budget is first
balanced. In the scenarios, “r-g” is the rate of interest minus the rate of economic growth.
% of GDP
110
100
90
80
70
60
50
0 1 2 3 4 5 6 7 8 9 10
r-g=-3 r-g=-2 r-g=-1 r=g
Debt and budget deficit sustainability
One academic approach (Modern Monetary Theory) argues that debt levels are not a problem
and some pragmatic government and central bankers (note former Fed chair and current treasury
secretary Janet Yellen recently in the U.S.) have indicated that reducing debt levels is not an
immediate priority. Low debt service costs in the current low interest rate environment are one
important factor reducing pressure to wind down debt.
But there are two reasons why budget deficits are not likely to become eternal.
First, interest sensitivity can become extremely high. As noted, low debt service costs are a great
help to indebted countries at present. But in the future markets will start to differentiate more
between countries – especially in times of crisis. Low policy rates do not by themselves imply
low risk premiums. When things worsen, countries could come quickly under pressure. As the
Eurozone crisis of 2009-2012 demonstrated, risk premiums can rise very fast when confidence in
one country’s credibility is challenged.
Secondly, we should not underestimate potential inflationary pressures from higher fiscal
spending. Economic slack (from higher unemployment levels, subdued consumer confidence and
the output gap) is likely to keep price pressures for the months ahead low. But when inflationary
pressures start, they can then grow quickly (e.g. when full employment has been achieved). This
is most likely an issue for the long term, not the short term. Inflationary pressures may also unfold
when the velocity of circulation of money increases.
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Financial repression:
still restraining real rates
For now, the situation appears manageable. In fact, as maturing debt is replaced by lower-yielding
bonds, debt service costs as a percentage of outstanding debt in general will decrease. For some
countries, like Germany, where the majority of bonds outstanding have a negative yield, it could
even turn positive over time. So – paradoxically – by issuing debt, the state is actually earning
money.
In the absence of financial stress, even large budget deficits and high debt to GDP ratios can be
sustained over a long time period. As long as financial actors believe that outstanding debt will
be repaid (and in the absence of other investment with better perceived risk-return profiles) even
negative yielding bonds will be bought.
However, other factors need to be considered.
First, while we do not think that governments will want to risk suppressing the business cycle in its
early stages, in the medium term the probability of increased taxes is high – and is already being
discussed in many countries. This may in part be driven by legislation: in Germany for example
the government is forced by law (the so-called “debt break”) to reduce the additional debt taken
2020 and 2021 and to bring it back to levels below 60% to GDP. EU countries with the Euro as
their official currency are obliged by EU agreements to have a strategy to reduce their debt to
levels seen as sustainable. Higher taxes are a means to increase government revenues and thus
ultimately reduce debt and debt payments. Very recently U.S. President Biden has launched an
initiative for higher corporate taxes.
Second, faith in further liquidity injections could fade. As we had already seen before the
coronavirus pandemic, stimulus amounts had been forced to become more generous due to the
reduced marginal utility of each unit of stimulus. There is a fear that monetary policy may stop
being an effective tool.
Financial repression, fiscal policy and debt
o Fiscal policy has played a major role supporting economies over
the pandemic, resulting in a substantial increase in debt levels.
o "Traditional" options of growing your way out of debt, or relying
on inflation to ease the debt burden, do not look viable this time
around.
o Heavy financial repression is therefore needed to manage the
debt burden – and multiple factors suggest we cannot assume
high fiscal deficits are sustainable for ever.
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Financial repression:
still restraining real rates
04 Possible future scenarios
As we touch on above (and explain in detail in our report Peak Debt: Sustainability and investment
implications), there are in principle six ways of escaping the debt trap: 1) pro-growth policies (e.g.
structural reforms); 2) growth because of productivity gains (not driven by governments);
3) expenditure cuts; 4) revenue-boosting measures (e.g. tax hikes); 5) inflation and 6) debt “hair-
cuts”/defaults (e.g. a “bail in” of debt holders).
Of course, in reality some of these can operate in tandem – for example, a combination of
expenditure cuts and tax hikes could be seen as an austerity strategy. However, “hair-cuts” and
defaults are worth avoiding as access to capital markets will be negatively affected.
With regards to the current financial repression environment, four possible scenarios are worth
focusing on – and they are likely to overlap too:
Figure 8: Future scenarios
Source: Deutsche Bank AG. As of April 9, 2021.
Scenario A Scenario B Scenario C Scenario D
“Policy maintained” “Structural reforms” “Inflation” “Stagflation”
Demand-driven Inflation with
No policy shift Structural reforms
reforms slow growth
Policymakers manage
Low GDP growth, Difficult transition to
growth/rates/ Higher interest rates
low inflation higher growth
inflation balance
Debt levels stable
Debt levels reduced Slow growth
or higher
High debt levels
A Policy maintained; austerity avoided. Without major changes, economic growth may
continue to be low. In an effort to please electorates, governments will avoid austerity
(note the recent discussions on the debt brake in Germany). As a result, government
debt levels will (at best) stay broadly constant; they are more likely to continue to
rise. Central banks will therefore need to maintain a low rates environment (at least
in a historical context). As long as inflation does not kick in, putting central banks in a
difficult situation, investors will be faced with low rates for some time. Such a scenario
can last for a pretty long time, as the example of Japan demonstrates.
B Structural reforms and austerity. Governments introduce structural pro-growth
reforms (e.g. de-regulation, postponement of retirement age) and also pursue fiscal
austerity (public expenditures shrink and/or taxes are raised). This path can be thorny
for politicians as their electorate has to make sacrifices – and there can be a long gap
between the implementation of such policies and their eventual success. But resumed
growth, along with fiscal control, should pull down debt-to-GDP ratios and result in
higher interest rates and the end of financial repression. This scenario is more likely in
regions like the U.S. than in the Eurozone, where different national governments are
embedded in a common monetary framework.
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Financial repression:
still restraining real rates
C Inflation. The ultimate goal of low yields imposed by central banks may be to create
inflation. Higher inflation increases nominal GDP while the nominal debt level remains
(ceteris paribus) unaffected. Here financial repression creates a transfer from the
creditor to the debtor in real terms. At present, immediate inflation pressures seem
moderate, given the still low growth environment. However, over the medium term
inflation pressure may pick up when economies reopen, production capacity is fully
utilized and pent-up demand meets limited capacity in the services industry. A loss
of purchasing power is an obvious consequence and financial repression could even
intensify if yields do not follow suit and rise to follow inflation. Central banks should,
however, be willing and able to combat too-high inflation rates by tightening financial
conditions and raising rates. Nevertheless, for a certain period of time (and central
banks have been unwilling to define this time frame) many now appear willing to accept
inflation rates above their previous goals – the Fed, for example, has introduced a long-
term average inflation goal.
D Stagflation. Rising inflation along with rising yields can, however, result in a very
unpleasant combination from both an economic and investor perspective. If rates rise
fast they can dampen economic activity as refinancing becomes more expensive and
investments have to yield higher returns. High inflation rates can also result in higher
wages creating an inflationary spiral ultimately resulting in stagflation: stagnant output
and high inflation. The immediate consequences of rising yields for bond holders are
losses. And still if inflation rates are higher than yields, financial repression continues.
For equity investors a low growth/high yield environment has multiple challenges.
Looking across countries, it is possible that we will get a combination of these scenarios – some
economies lifting themselves out of their current situation and others getting stuck.
Possible future scenarios
In the current financial repression environment, four scenarios (or a
combination of them) look possible:
o Keeping policy broadly “as is”, and hoping that this can keep debt
levels stable.
o Making radical and painful reforms, hoping that eventual stronger
growth will reduce debt.
o Relying on increased inflation to reduce debt levels, which may
require a complex policy balancing act.
o Risking stagflation, where high inflation is unfortunately
accompanied by static or falling output, pushing debt up further.
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Financial repression:
still restraining real rates
05 What this means for investors
Asset class trends
Financial repression in its current form makes capital preservation (even in nominal terms) even
more of a challenge. High grade bonds no longer provide meaningful positive nominal yields (in
many cases they are even negative). Despite recent rise in nominal yields in the U.S. real yields
continue to be negative. For Europe this is even still the case for large parts of the yield curve.
This requires a change in thinking when it comes to asset allocation. Acceptance of risk is a
prerequisite for returns, but this implies that investors are able to define their strategic goals and
their willingness to accept risks. These parameters can be either temporary or structural in nature.
Falling interest rates have particularly supported equities. As can be seen by the high correlation
of real yields and valuations (Figure 9), a large part of the increase of the broad S&P 500 in 2020
can be explained statistically by higher multiples due to lower real yields.
Figure 9: The S&P 500 price/earnings (P/E) ratio and the real U.S. 10-year yield
Source: Bloomberg Finance L.P., Deutsche Bank AG. As of April 9, 2021.
P/E ratio %
30 -2.0
-1.5
26
-1.0
22 -0.5
0.0
18
0.5
14 1.0
2014
2015
2016
2017
2018
2019
2020
2021
S&P 500 P/E ratio (NTM, LHS) 10-year U.S. Treasuries real yield (in %, RHS, axis inverted)
Low interest rates have particularly helped boost certain types of equities by changing the extent
to which we “discount” the future. “Growth” stocks are companies whose earnings are expected
to grow strongly in the long term: such growth can be explained not just by structural reasons
(e.g. technology trends) but also by accounting. Such companies’ future profits are now less
discounted (by lower risk-free interest rates, i.e. highly-rated government bonds) and are therefore
more worth from today’s perspective. So financial repression has led to shifts – by sector and by
country – with valuations of specific industries growing more than others, and country indices
with a higher proportion of such “growth” stocks performing relatively well.
For fixed income investors the world looks very different. Earning a return that is higher than
inflation is harder than ever, especially for Eurozone investors where, even below investment
grade, bonds have very low yields. To enhance the return possibilities bond managers have had to
increase their risk profile when it comes to duration, credit and currency risk. This makes returns
less predictable and prone to volatility.
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Financial repression:
still restraining real rates
Real assets, aside from equities, have benefitted from falling yields. The gold price reached new
all-time highs in 2020: the fact that gold does not pay any coupon is no longer a disadvantage
when overall interest rates are low or negative (Figure 10 shows the link). In relatively illiquid asset
classes like real estate or private equity where long-term financing plays an important role, the
favourable financing conditions for investors have led to stretched valuations.
Figure 10: Gold and real interest rates
Source: Bloomberg Finance L.P., Deutsche AG. As of April 9, 2021.
2100 -1.5
1900 -1.0
1700 -0.5
1500 0
1300 0.5
1100 1.0
01/18
03/18
05/18
07/18
09/18
11/18
01/19
03/19
05/19
07/19
09/19
11/19
01/20
03/20
05/20
07/20
09/20
11/20
01/21
Gold (in USD/oz, LHS) 10-year U.S. treasury real yield (in %, RHS, axis inverted)
Rising real yields: causes and challenges
As an escape route from financial repression, investors may hope for an increase in real
(rather than nominal) yields over the longer term. However, any longer-term increase in
real yields would create challenges as well as opportunities. On the fixed income side, an
increase in real yields could be driven by rising nominal yields (assuming that inflation
does not rise too), and rising nominal yields are associated with a fall in security prices –
implying a rather unsettling path to normalization for an investor concerned about future
income sources. Conversely, if the rise in real yields is due to a fall in inflation (rather than
a rise in nominal yields), then central banks will do “whatever it takes” to combat what they
may well see as dangerously low inflation rates, suppressing interest rates even further to
encourage economic growth and thus (they hope) demand-driven inflation. Hence financial
repression would be likely to continue.
On the equity side the picture would also be complex in a rising real yields environment,
but in rather different ways. Real rates and equity prices are generally positively correlated.
When the former rises, the latter usually does too: from a fundamental perspective, an
increase in real yields can be associated with better GDP growth prospects, which should
in turn be advantageous for equities. Swift moves in real rates, however, can lead to this
correlation between rates and GDP growth turning negative, posing a short-term risk
to equity markets. Negative real yields have resulted, as we can see, in elevated price/
earnings (P/E) ratios. If real yields rise, we should expect a more earnings-driven market,
with P/E multiples likely to decrease. As we discuss above (on page 15) the fall in yields
had also had differing implications for different sectors, in part because it affects how we
discount future earnings. Higher yields therefore could also result in a style rotation from
growth to value stocks, as it would force investors to increasingly discount future earnings,
reducing the relative attractiveness of growth companies.
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Financial repression
repression:
still restraining real rates
Investment responses
As we argue above, financial repression is likely to be with us for some years. Investors therefore
need to accept it and plan accordingly.
One obvious response might appear to be to allocate a higher portion of your strategic asset
allocation to equities. But tail risk events (as we have been brutally reminded by the coronavirus
pandemic) demonstrate that diversification remains key to any strategic asset allocation as
situations can change unexpectedly and rapidly. For a discussion of diversification within
portfolios, please see our report, Diversification: managing eggs and baskets.
Overall, the impacts of financial repression for markets is both powerful yet simple. The lack of
opportunities for positive real returns on safer assets forces investors further out along on the risk
curve. For those asset classes which are favoured, this stretches valuations to new highs, which
can be particularly problematic for certain types of investors that would normally want to target
lower weights for risky assets or institutions that are bound to a fixed nominal return target.
In equities, as noted above, financial repression pushes up valuations in a number of ways.
Even stocks of companies with above-average dividend yields or pay-out ratios may experience
exaggerated performance, being regarded as bond-proxies by traditional fixed income investors
who are forced to accept a lower position in the capital structure pecking order. (The negative
is that certain rate-sensitive industries, such as banks, may face profitability pressures from an
artificial suppression in yields.)
However, the ability of fixed income investors to buy more risky assets may be limited by this or
other regulatory hurdles. These restrict certain types of institutional investors (e.g. pension funds)
regarding credit quality, meaning that they may not have the flexibility to extend out on the risk
curve. Such investors may have to lock in yields at negative real levels and follow a more active
approach, depending on additional financial repression in the future to further boost the value of
some fixed income investments.
As we have discussed above, repression of interest rates eliminates opportunity costs for non-
interest bearing assets such as gold or other precious metals. Historically, the move in real
yields goes in step with this, with some now thinking (not convincingly in our view) that crypto
currencies may play a similar role. Real assets are far from risk-free, however.
So, in summary, while financial repression may reduce economic risks, a portfolio response to it
may involve increasing risk – achieving reasonable portfolio returns may require increasing equity
exposure, or venturing into more risky fixed asset investments, or exploring the world of real
assets, or a combination of these approaches. This may make for an uncomfortable ride, even if
the current problems with the pandemic are dealt with effectively – as the 2013 taper tantrum
demonstrated, the process of even slight policy “normalisation” is inherently risky. Financial
repression therefore makes effective risk-management in portfolios even more important.
Portfolio implications
o Low interest rates have helped boost equities and some other real
assets. Certain sorts of equities have particularly benefited from
changes to the extent we “discount” the future.
o For fixed income investors, the world looks very different, but the
ability (and willingness) of such investors to increase risk may be
limited by various factors.
o Financial repression therefore demands a well-considered
portfolio response, or else higher levels of risk may make for an
uncomfortable ride, even if current problems with the pandemic
are dealt with effectively.
Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at
risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 17CIO Special
Financial repression:
still restraining real rates
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risk. Readers should refer to disclosures and risk warnings at the end of this document. Produced in April 2021. 18CIO Special
Financial repression:
still restraining real rates
Glossary Baby boomers are generally defined as those born between 1946 and 1964.
The European Central Bank (ECB) is the central bank for the Eurozone.
The Federal Reserve (Fed) is the central bank of the United States. Its Federal Open Market
Committee (FOMC) meets to determine interest rate policy.
Financial repression is a policy of keeping interest rates at very low or negative real levels.
The G20 is an international forum of the governments and central-bank governors from 19 individual
countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy,
Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the
United States—along with the European Union (EU).
The Global Financial Crisis refers to the financial and economic crisis that started in 2007-2008.
The International Monetary Fund (IMF) was founded in 1994, includes 189 countries and works to
promote international monetary cooperation, exchange rate stability and economic development
more broadly.
Modern Monetary Theory (MMT) is a heterodox macroeconomic framework that, in some forms, says
monetarily sovereign countries like the U.S., UK, Japan and Canada are not operationally constrained
by revenues when it comes to federal government spending.
Market concentration
Quantitative easing (QE) is an unconventional monetary policy tool, in which a central bank conducts
a broad-based asset purchases.
R* is the natural rate of interest, which (in theory) brings an economy’s output in line with its potential
output.
Stagflation is a situation where economic growth is slow (or negative) but levels of inflation are high.
The yield curve shows the different rates for bonds of differing maturities but the same credit quality.
Yield curve control is where a central bank targets part of the yield curve, buying (or selling) these
bonds to keep yields (and therefore prices) at what it believes to be appropriate levels.
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Financial repression:
still restraining real rates
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