In 2014, the biggest economic story was the dramatic collapse of oil prices. But perhaps more surprising to both economists and bond traders has been the dramatic fall in US yields despite clear signaling from the Fed that rate hikes are coming in 2015. However, cutting edge research from the Bank for International Settlements suggests that the drop in long term yields in the US, and also notably in Australia and New Zealand is not a mystery at all. On the face of it, this research is simple in premise. Just like any other security or commodity, the price of long term assets (and thus yields) are driven by supply and demand, not a "stacking up" of shorter term interest rates. Thus, the dramatic fall in the supply of long term assets relative to demand, in most cases due to large scale asset purchases by central banks, explains the fall in yields even in the face of rising short rates.
Bernanke’s “Global Savings Glut”
In 2005, the future Fed Chairman Bernanke delivered highly influential lecture on bond yields which sought to explain the so-called “Greenspan Conundrum” whereby aggressive hikes in the Fed Funds Rate beginning in 2004 failed to increase long term bond yields (or mortgage rates). Bernanke believe that a global glut of dollar reserves from abroad, mainly the result of large US current account deficits, were being recycled back to the US as foreign investors piled into US Treasuries and Agency debt. While Bernanke made many insightful observations about why high savings rates abroad might contribute to low long term interest rates, he completely ignored the supply side of the equation. A glut of savers could equally be seen as a dearth of borrowers and/or long dated assets. A key factor missed by both the Treasury and the Federal Reserve was that the supply on long term investment outlets was falling rapidly, and this was the direct result of government policy. Beginning in 2002, the US Treasury department radically shifted course by issuing a large number of short term bills relative to longer term bonds. In 2006, right before the yield curve inverted, the average weighted maturity on US Treasury securities held by the public stood at a historic low of 43 months. The net supply of new long term Treasury bonds being supplied to the market was falling, and falling fast.
Fundamentally, what Bernanke failed to grasp was that there is and will always be a strong demand for long dated Treasury securities. Regulatory and institutional features are the main drivers of this highly price inelastic demand. In general, banks are required to hold zero capital against US Treasuries because they are correctly judged as risk free. Insurance companies, which have many long term liabilities and thus match them with long term assets, are required to hold large percentages of their portfolios’ in government bonds. Liquidity requirements also play a role. Large financial institutions are required to hold a certain amount of highly liquid assets, and the most liquid bond on the planet is the US Treasury.
Supply Effects Persist
Later, Dr. Bernanke would become Fed Chairman, and would exploit supply effects in the Treasury and Agency MBS markets to push down long term interest rates. The reserve creation brought on by the various rounds of QE was meaningless because the price of reserves was already zero. In contrast, QE removed long dated assets from the private marketplace. This is the economic equivalent of the Treasury funding itself with more bills rather than bonds. In sum, QE caused investors already starved for yield to compete for even fewer Treasury bonds, which bid down yields even further.
Something else happened in 2009. The deficit exploded because of collapsing tax receipts, and the US Treasury faced a humongous financing task. However, in what now is recognized to be a highly unproductive course, the Treasury decided to finance the deficit with mostly long term bonds rather than bills. This may or may not have been consistent with the Treasury’s mandate to achieve the lowest possible borrowing costs for the taxpayer. (A mandate that should be reconsidered) But there is no doubt that it was highly disruptive to the implementation of monetary policy. Just as the Fed’s was desperately trying to remove long dated assets from the market, the Treasury was boosting the supply of them. 2010 minutes of the Treasury Borrowing Advisory Committee reveal that the Treasury is loathe to acknowledge Fed actions when making borrowing decisions, viewing that as nothing more than another “large investor.” Strikingly, the supply effect was also noted yet dismissed,
At this point, a member asked about the impact of the Fed's potential
quantitative easing (QE2), expected to be announced at the November
2010 FOMC meeting. The question arose regarding whether the Fed and the
Treasury were working at cross purposes, given that Treasury is
extending the average maturity of the portfolio while the Fed is
expected to purchase longer-dated securities. The member noted that
from an economic perspective, the Fed's purchase of longer-dated coupons
via increasing reserves was economically equivalent to Treasury
reducing longer-dated coupons and issuing more bills.
The same minutes even openly acknowledged that the Fed and Treasury are “independent institutions whose objectives may at times appear to come into conflict.” The Treasury's insistence on changing its funding strategy even when it disrupted the implementation of monetary policy calls for a re-examination of the Fed-Treasury relationship. Specifically, two institutions control the aggregate supply of US Treasuries, the Fed and the Treasury itself. And, if the supply of US Treasuries is major determinant of long term interest rates and thus a monetary policy variable, coordination, not independence or mutual ambivalence, is required to implement policy objectives.
Today's Environment
In October 2014, Fed purchases of Treasury bonds finally ended, but Treasury rates have kept falling. However, yet again a simple supply story can explain this drop. Indeed, in 2010 when the deficit peaked at 10 percent of GDP, net issuance of long term Treasuries topped out 1.2 trillion dollars. Net issuance in 2013 of Treasury notes was 644 billion dollars, while in 2014 this figure fell to 576 billion dollars, a drop of 70 billion. This dramatic reduction in net issuance is exclusively the result in the shrinking deficit, itself a product of the improving economy. Therefore, the Treasury began supplying less long dated Treasuries to the market precisely as the Fed has phased out its purchases of Treasury assets. The net economic result is that the private market is being supplid with less Treasuries, which causes the prices of these very securities to be bid up.
The fall in Treasury yields is not the bond market's way of pricing in disaster. Rather, it is simply a reflection of the sharp reduction in the supply of new Treasuries over the past few years. Should the Fed move to raise rates on the short end of the curve, the result will be a flattening of the term structure, not a parallel shift in long term rates. In fact, we already have a test case for this. The Reserve Bank of New Zealand hiked the overnight rate by 150 basis points in 2014, while at the same time public debt in New Zealand is very low. This created a scarcity of long dated NZD denominated assets, which many investors are required to hold for regulatory reasons. The result has been (unsurprisingly) an inversion of the NZD yield curve. Fixed income investors can rest easy. A shrinking deficit all but ensures a greater scarcity of Treasury notes and bonds. Flatter yield curve here we come.
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