Why are Bond Yields Still so Low?

One of the fundamental conclusions of basic macroeconomics is that when the economy booms, interest rates should rise. That’s because when the economy is doing well, people and businesses borrow more money to finance their spending and investment. When the demand for borrowed money rises, we know that the cost of borrowing money will rise – i.e. interest rates will go up. And lately we’ve had a raft of data showing that the economy is recovering very nicely, thank you. GDP growth was revised up to 8.2% in the July-September quarter. Employment grew in September and October. Home construction is at record levels.

If the economy is improving so strongly, then why in the world have long-term interest rates fallen over the past two months?

The Economist’s Buttonwood column has this to say about it:

The simple explanation for this… is that investors sense a chill beneath the warm glow of the numbers. One cold wind blowing across this particular recovery is that Americans are up to their necks in debt. With short-term interest rates at a 45-year low, households are spending some 13% of their disposable income on servicing their debts—a higher number even than in the sharp recession of the early 1980s, when the Federal funds rate topped 13%. How much longer can they carry on spending at this rate, let alone increase it? If they don’t, then someone else will have to spend on their behalf.

The government, perhaps? The Bush administration has turned a budget surplus of 2.4% of GDP into a deficit that official numbers say will amount to 4.3% of GDP next year. Not much room, in other words, to raise spending. Nor do American companies have oodles of money to play with. For all the talk of restructuring, they continue to increase their borrowing, though at least a slowdown in the rate at which they borrow and better profitability mean that their dreadful financial ratios are starting to look better than they were. Whether they will continue to do so is another matter.

This echoes the concerns that I raised in this earlier post. But The Economist goes on to add that there’s a more fundamental problem that the US economy will be facing over the next several years: the economic leadership of George Bush. As Buttonwood puts it, “George Bush is a man who wants to get re-elected and seems prepared to sacrifice the long-term economic good—assuming (a big assumption) he knows how it is best served—to get back into the Oval Office.”

Good point.