There is an adage among population experts that demography can explain two-thirds of everything. Nowhere is this more evident than in understanding the forces behind the fall in inflation and the accompanying fall in bond yields over the past 30 years. With all the speculation about the demise of the bull market in bond yields and the heralding of the return to higher interest rates, we need to step back and examine the forces that gave rise to the persistent decline in yields since the early 1980's.

We are all familiar with the Japanese economy which has suffered from a steady decline in the total population and the accompanying decline in its working age population. Consequently, Japan experienced twenty years of deflation. Projections call for Japan to shrink by as much as 30% at the end of 2050, reinforcing the view that low inflation (if not outright deflation) will dog that economy indefinitely. Demographers worldwide consider that Japan is the “canary in the coal mine”, a harbinger of what to expect for other advanced economies.

In the United States, studies have pointed out the correlation between the aging of the population and the decline in inflation and interest rates. Figure 1 traces the movement in consumer prices, the U.S. 10-year yield and the percent of the labor force between the ages of 16-54 -  the prime working years. During this long period, the entire structure of interest rates can be traced to the decline in the most important demographic ratio of middle-aged to young population.

           Figure 1

Furthermore,  U.S. Bureau of Labor Statistics projects the labor force to grow over the next 10 years at annual rate of 0.5%, the slowest in the last two decades. What was started nearly 30 years ago will continue to slow growth and maintain low interest rates (Figure 2)

            Figure 2

So, what is the connection between slow labor force growth and interest rates? Why does population growth and its fluctuations matter for interest rates? The answer turns on who are borrowers (and spenders) and who are savers. Younger cohorts are generally borrowers, only to become savers as they age into their middle years and later into old age. As the population ages, they tend to save more relative to their younger members and this not only reduces pressures on the inflation rate, but at the same time, increases the demand for safe investment vehicles such as government bonds.  In other words, the relative number of savers and borrowers impact the market for loanable funds.

When former Fed chairman, Ben Bernanke, was asked why long-term rates world were so low, he stated flat out that there was a world surplus of savings that needed to be channelled into safe liquid assets. That is, we are witnessing a “borrowers’ market” which results in low interest rates. The United States notoriously has one of the lowest saving rates (less than 3% of GDP). China and Germany, for example, have very high savings rate a high as 30% of GDP. The buildup in net savings internationally will continue to keep interest rates low for many years to come.