Global Interest Rates Update

Late last year I wrote about global interest rates. I attempted to rationalize the eye-popping disparity between U.S. and foreign government bond interest rates. Today, doing some work for a class I’m teaching, I once again noticed something pretty amazing. U.S. ten year notes have a yield of 2.017%. Germany and Japan are in the vicinity of 0.3%. That will get anyone’s attention.[1] This is your global interest rate update. As always, my methods are transparent. Click here to download the Excel workbook (includes both monthly and annual data).

Before proceeding with the update, I must confess a minor error in my previous article. My equation for the default risk premium was much more complicated than necessary. I’ve corrected my mistake below.

Data

So first let’s look at interest rate trends. For some reason, Japan’s data is only reported through October, 2014 in the OECD dataset. I’ll exclude that country just to keep the data comparable by using a single source.

Here are a few representative countries. As always, the yield to maturity shown is on the ten-year government note. I assume (hope?) that OECD has corrected for coupon payments in putting these numbers together. This time I have included only one eurozone country, Germany.

 

Interest Rates

Monthly Interest Rates, 2014 (click the image to enlarge)

Notice something very interesting. The data falls into three rough groups. (Russia, the top line, is a special case.) The first group with interest rates around 4% includes Chile, New Zealand, and Australia. It’s fairly easy to understand why New Zealand and Australia might move together. A simple gravity model of trade will tell you these economies should be closely linked. But Chile? Is there a strange southern hemisphere effect? The data is there — I leave it to more intrepid researchers to figure this out.

The second group consists of Israel, the U.K., the U.S., and Canada. These four countries are linked by a shared language and historical ties. And, of course, the U.S. and Canada have both the gravity model and NAFTA to encourage economic linkages.

The lowest two countries are Germany and Switzerland. In fact, in January, 2015, the yield on Swiss government bonds was -0.07%. This is the nominal rate. Savers are paying the Swiss government for the privilege of lending it money.

Expected Future Exchange Rates

We can explain some of these interest rate differentials by using the uncovered interest parity (UIP) model: [2]

Uncovered Interest Parity

This equation simply says that the yield to maturity on U.S. bonds should equal the yield on euro bonds plus the expected future depreciation of the dollar vis-à-vis the euro.[3] When the dollar depreciates, one euro will buy more dollars. Thus a dollar depreciation increases the required return on U.S. securities, causing their interest rate to rise.

Here’s the expected depreciation (+) or appreciation (-) of various currencies vis-à-vis the U.S. dollar. I’ve excluded countries that did not have data for January, 2015. Some of the depreciations are truly remarkable. Not surprisingly, Russia is the leader in this group with expected annual depreciation of 23.85%. Iceland is also notable with 14.54% annual depreciation.

Expected Exchange Rate Changes

Expected Exchange Rate Changes

Currencies expected to appreciate sharply include the Swiss franc and the Swedish kronor. The eurozone countries are interesting: Belgium (−11.3%), Finland (−12.6%), Germany (−14.90%), the Netherlands (−13.60%) and Spain (−3.36%) all use the same currency. But the expected rates of depreciation are markedly different.

Default Risk

The only way to make sense of this is to introduce another variable: default risk. We can calculate the default risk premium as the difference between yields on government bonds issued by different governments but denominated in the same currency.

The usual explanations for interest rate differentials among various countries are (1) differential inflation rates and (2) expected future exchange rate changes. Naturally the two are related. However, expected future exchange rate changes also incorporate a variety of other risks, including exchange rate risk and default risk. The appropriate short-run model is a slight modification of UIP.

Default Risk Equation 

In this equation, i€P is the yield on government securities for countries in the P group.[4] Similarly, i€G is the yield on German government securities. In the eurozone, German government securities are the benchmark against which other countries are measured.

What, then, is the meaning of the expected change in the exchange rate, the term on the right side of the = sign? The Greek euro cannot depreciate against the German euro. In this case, we are measuring the default risk premium of the various countries.

To measure this I’ll use data from December, 2014 because all the eurozone countries have data reported for that month. Also note that we apparently need to change the acronym. Markets seem to think that Ireland has worked their problems out. But Slovenia is now in the mix. I propose PIGSS, mainly so I don’t have to change a bunch of subscripts in this article.

Default Risk Premiums

What’s really interesting about this list is that only Luxembourg approaches Germany’s level of stability. And France’s default risk premium is higher than you might expect for the second-largest economy in the eurozone.

Conclusion

Wasn’t that fun? I hope you’ve learned a bit about using data to learn something interesting.

[1] OECD (2014), “Finance”, Main Economic Indicators (database). DOI: 10.1787/data-00043-en (Accessed on 27 February 2015)

[2] Material on UIP is based on chapter 4 from Robert C. Feenstra and Alan M. Taylor, International Macroeconomics (2012). Worth Publishers, New York. Disclaimer: I wrote the instructor’s resource guide for this textbook.

[3] It has become conventional to express exchange rates as units of home currency per unit of foreign currency. That means an increase in the exchange rate implies a depreciation of the home currency and vice-versa. This is only confusing the first 247 times you work with it. After that it’s simple.

[4] P stands for PIIGS, the five countries in the eurozone that have very risky government debt.




Global Interest Rates

The other day, someone I regularly read on Twitter (@DividendMaster) noticed something interesting about interest rates, specifically ten-year government notes in OECD countries.[1] (As always, my methods are transparent. Click here to download the Excel workbook (includes both monthly and annual data).

Take a look at this and see if you notice anything interesting:

 

Monthly Interest Rates, 2014 Global Interest Rates

Monthly Interest Rates, 2014 (click the image to enlarge)

That’s pretty hard to read. Here’s a closeup of the last three months:

Interest Rates, Last Three Months Global Interest Rates

Interest Rates, Last Three Months (click for a larger image)

Yes, you’re reading that right. The U.S. interest rate was the highest among these six countries in September. Spain and Italy? Really? (If it’s any relief, the interest rate on Greek sovereign debt was 5.89%, indicating that there is at least some sanity in the world.)

Also note that France and Germany are borrowing at interest rates considerably less than what the U.S. is paying.

The usual explanations for interest rate differentials among various countries are (1) differential inflation rates and (2) expected future exchange rate changes. Naturally the two are related. However, expected future exchange rate changes also incorporate a variety of other risks, including exchange rate risk and default risk.

Let’s assume the risk of U.S. default is less than either Italy or Spain. We need a theory of expected future exchange rates. The appropriate short-run model is uncovered interest parity (UIP).[2]

Uncovered Interest Parity

UIP theory says the interest rate[3] on comparable securities in two countries should be equal after adjusting for expected future exchange rate changes.[4]

 

Uncovered Interest Parity

Uncovered Interest Parity

Thus we see the expected rate of depreciation of the dollar is equal to the interest rate differential. We can use this to construct the following table:

 

UIP in Action Global Interest Rates

UIP in Action

The markets are saying the U.S. dollar is overvalued with respect to these currencies. The dollar is expected to depreciate vis-à-vis each of these countries.

But there’s still one problem. All these countries except the U.K. and the U.S. use the euro. How can the dollar be expected to depreciate by different amounts against a single currency? It can’t. There is only one spot U.S. dollar – euro exchange rate. The remaining differences must be due to default risk.

Default Risk

Let’s assume Germany’s sovereign debt has about the same risk as U.S. government securities. We need to modify our UIP equation to account for default risk. The easiest way is to simply define the default risk premium as follows:

UIP With Default Risk

UIP With Default Risk

where the subscript $/€G refers to the expected depreciation of the dollar vis-à-vis the euro in Germany and $/€O is the apparent expected depreciation of the dollar vis-a-vis another Eurozone country. Thus we have the following premiums for the risk of default:

 

Default Risk PremiumsDefault Risk PremiumsGlobal Interest Rates

Default Risk Premiums

Conclusion

What’s really interesting about this is that Italy is viewed as higher risk than Spain. Default risks for other Eurozone countries are in the Excel workbook.

[1] OECD (2014), “Finance”, Main Economic Indicators (database). DOI: 10.1787/data-00043-en (Accessed on 21 December 2014)

[2] Material in this section is based on chapter 4 from Robert C. Feenstra and Alan M. Taylor, International Macroeconomics (2012). Worth Publishers, New York. Disclaimer: I wrote the instructor’s resource guide for this textbook.

[3] “interest rate” means “yield to maturity” here and throughout.

[4] Feenstra & Taylor, p. 113.




Misunderstanding Default Risk

“In a sign of the fragile investor mood, gold surged to a new high of $1,628.30 a troy ounce. Investors also piled into Treasuries, driving down the yield on the benchmark 10-year note sharply to 2.804%, its lowest close since last November. Yields, which fall as prices rise, cratered as investors searched for a safe haven ahead of the Aug. 2 debt-ceiling deadline.”
– Wall Street Journal, July 29, 2011, “House Passes GOP Debt Plan” by Naftali Bendavi and Carol E. Lee (may be available at http://online.wsj.com/article_email/SB10001424053111904800304576475922394400688-lMyQjAxMTAxMDIwOTEyNDkyWj.html)

Huh??

This from the former “premier business daily” in the U.S.  Students in my microeconomic principles class could figure out what’s wrong here.

Hey, Wall Street Journal writers: who has to pay those Treasury notes?  That’s right, the U.S. government.  Arguing that investors are buying those securities because they expect the U.S. government to default is, well, stupid.

The Murdochization of the Journal reaches yet another new low.




Financial Literacy Month

Sometimes they make my job too easy.

An April 4 joint press release by the Federal Reserve Bank of Chicago and Visa, Inc. trumpeted the main points made by speakers at the National Literacy Summit.  Earlier — March 31, 6:52 pm, although delaying the announcement by six hours would have made more sense — President Obama announced that April was National Financial Literacy Month.  My irony meter exploded.

This from the guy who gave us government budget deficits of over $1 trillion.  There is at least some evidence that global credit markets have added about 20 basis points to the yield on ten-year government bonds to reflect the increased default risk.