As I start getting reaquainted with the financial press following my 10-day ‘vacation’, the first thing that has caught my attention is the continued fall in long-term interest rates. The ‘conundrum’ about which Alan Greenspan spoke a few months ago has not resolved itself, after briefly appearing as though it might back in March. Instead, the mystery has deepened, in the sense that long-term interest rates have fallen noticeably over the past month or two even though the Fed continues to increase short-term interest rates. (See Mark Thoma for a few more recent viewpoints about this puzzle, mystery, conundrum, or whatever you want to call it.)
The following chart shows the essence of the interest rate mystery: short-term rates keep rising, while long-term rates don’t.
Of particular surprise to many observers, in recent weeks the bond market has completely reversed the rise in yields that we saw a couple of months ago. This resounding defeat of the bond market bears has been so striking as to convince some of them, like Stephen Roach, to give up being a bear altogether.
I don’t have any new theories to offer to explain the mystery. Just to recap, the prevailing theories to explain low long-term interest rates in the US are 1) the bond market expects the US economy to weaken, and thus expects inflation rates and private-sector borrowing needs to diminish; 2) corporate America is simply saving their profits, rather than spending them, thus limiting corporate borrowing needs and adding to current the supply of available savings; 3) there is a global glut of savings, which has driven interest rates down worldwide, including in the US; and 4) foreign central banks have been pushing such vast quantities of funds into the US treasury market that their actions have had a substantial impact on the US treasury market.
Obviously, these theories are not necessarily mutually exclusive, and the true explanation almost certainly involves some combination of some or all of these factors. The real question is therefore whether we can gauge the relative importance of these different effects.
Some more data may help to provide some insight into what’s going on in the long-term bond market. Plus, this is a good excuse for me to flex my slightly out-of-shape graphing muscles.
First, let’s break the long-term yield into its two components: the portion of the yield that compensates investors for expected inflation over the life of the bond, and the portion of the yield that comprises the real (after inflation) underlying rate of return.
Note: the real yield is the 10-yr TIPS (inflation-indexed) interest rate, while inflation expectations are the difference between the TIPS rate and the nominal interest rate.
Interestingly, over the past couple of weeks the fall in yields has been almost entirely due to a fall in inflation expectations. Meanwhile, the real (inflation-adjusted) yield has remained at historically low levels after a brief spike in March 2005. The recent decline in inflation expectations lends some support to hypothesis (1), that there is a growing belief that the US economy (or perhaps the world economy) may be weakening.
What about the idea that low US interest rates simply reflect low worldwide interest rates? The next chart compares long-term interest rates in the US with those of the euro zone:
Over the past six months an unusual gap has opened up between German government bond yields and US government bond yields. This lends some credence to hypothesis (3), which suggests that today’s low long-term interest rates are a world-wide phenomenon rather than being particular to the US, and reflect a global abundance of savings and/or a dearth in global borrowing by corporations to undertake investment projects. The gap also suggests that the bears were right and long-term interest rates in the US actually have risen – when compared to interest rates in the rest of the world. Brad Setser makes this point in a recent post.
My own particular take on this data is that I’m becoming more convinced that there is a growing sense in financial markets (at least the bond market) that economic growth is slowing, perhaps both in the US and in the rest of the world. I’ve been a firm believer in the impact of Asian central bank reserve accumulation on US interest rates, as well, and I’m sure that CB purchases of US government bonds have exacerbated the interest rate mystery. But I am becoming more and more convinced that there are other forces at work here than just that one.