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Greenspan's Mysterious Conundrum

Mises Daily: Tuesday, July 12, 2005 by

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Solving the low bond yield "conundrum" Alan Greenspan has frequently given various expressions a new meaning associated with contemporary economic phenonemas. First it was "irrational exuberance" in December 1996 to describe the stock market bubble which was then in its early stage. Then in February 2005 he described the surprisingly low yields on government Notes and Bonds as a "conundrum", meaning that he simply cannot explain why yields are so low.

That the Fed says it is puzzled by this phenonema means of course that they are trying to absolve themselves from any guilt for the low yields and the problems they create. But as we shall see, the Fed is guilty just as it was guilty of fueling "the irrational exuberance" of the tech stock bubble.

But at first glance the low yields on government securities does indeed seem like a conundrum. Since early 2000, the yield on the 10-year Note have fallen from 6% to 4% today. And since the Fed started its series of small interest rate increases a year ago, the yield has fallen from 4.6% to 4%. That any person would want to invest in a investment with a mere 4% yield denominated in a currency so prone to depreciation like the U.S. dollar does indeed at first glance seem like a conundrum.

Some people, including Larry Kudlow , have asserted that the decline in yields reflect falling inflation expectations. Yet that explanation fails since the yield on so-called inflation protected treasury securities have in fact fallen slightly more than the yield on regular government securities. So the decline in yields clearly reflect a decline in real yields or more strictly expected real yields.

Former Fed Governor Ben Bernanke, now CEA Chairman, have suggested that the answer is that the world is "suffering" from lower time preferences, which he refers to as "global savings glut". Rising savings in China and a dearth of investment opportunities elsewhere means that there is a global excess supply of savings that has nowhere else to turn something which has created a large capital inflow (aka current account deficit) to America which in turn has held down interest rates. This they argue is also illustrated by the fact that bond yields are at record lows in most other rich countries, and has fallen even more in other countries.

The high level of business profits around the world suggests that part of the explanation is that many companies have been unusually reluctant to invest , something which will other things being equal lower interest rates. However, the effect of this is largely counteracted by the decline in savings in most countries. Sharp house price increases in America and almost all other large economies except for Japan and Germany have induced consumer to reduce their savings sharply, counteracting the effects of the reluctance of corporations to invest. Moreover, governments in all G7 countries except for Canada are running budget deficits at very high levels , something which have also counteracted the effects of low business investments.

Frank Shostak argues that the higher rate of increase in Reserve Bank Credit , from 4.5% a year ago to 6% now explains the decline in yields. Yet while this is indeed part of the story as Fed purchases of government securities will clearly other things being equal lower the yield of those securities, the increase is not big enough to explain the entire decline. And increased money pumping by the Fed cannot explain why yields are much lower now than in early 2000, when Reserve Bank Credit increased at a rate of more than than 10%. In many other countries however, direct central bank money pumping have played a larger role in pushing down yields.

Others, including me , have pointed to the unprecedented massive purchases of U.S. government securities by central banks in particularly Asia but also Russia and other oil exporters. Throughout the 1990s and until 2001 when the dollar was still strong, foreign central banks typically bought a few tens of billions of dollars of U.S. government securities per year , . but in 2002 that number rose to $91 billion, in 2003 it rose to $224 billion and in 2004 it rose to $311 billion. That this massive flood of foreign central bank money has helped push up bond prices and therefore helped supress yields should be fairly obvious.

Yet while this is perhaps the single most important factor there has to be another factor involved here as yields have continued to stay low during 2005 despite decreased central bank purchases . During the first quarter inflow of foreign central bank purchases of U.S. government securities fell from an average $78 billion per quarter to $40 billion, yet yields only rose slightly (and has since returned to the previous lows). This factor must explain why by contrast foreign private purchases of U.S. government securities rose from an average of $26 billion per quarter to $75 billion the first quarter this year.

The other factor involved here is widely overlooked: namely expectations not of "low inflation" but of a continued inflationary monetary policy. Many people underestimate the extent to which even long-term interest rates are controlled indirectly by central banks. It is often asserted that while short-term interest rates is completely controlled by the central bank, long-term interest rates are complelely controlled by market forces.

But the fact is that central banks can artificially push down long-term interest rates not just by directly purchasing long-term securities with money created out of thin air, but also by creating expectations that future short-term interest rates will be low.

Many investors buy Notes and Bonds not so much because of the yield they currently give but because of a hope that their price will rise, just like most stock investors do not buy stocks primarily because of the dividend they give but because they hope stock prices will rise- And if investors believe that short-term interest rates will stay low then long-term securities will give a much higher return then the nominal yield.

This is both because if banks and investors believe that the average short-term interest rate during the coming 10 years will be 2% while current yields on 10-year Notes will be 4% then they can make money simply by borrowing short and lending long.

Of course given the risk there has to be a spread between long-term interest rates and expected short-term interest rates to compensate for the risk, but the point is that if the spread is big enough people will start engage in that form of arbitrage trade which will puch down long-term yields. And since the important thing is not so much current short-term interest rates but expected future short-term interest rates, raising the current short-term interest rates will have no effect on long-term interest rates unless it is unexpected and/or it causes people to believe that these increases will be more or less permanent, and do not instead signal that the peak of the interest rate cycle is approaching.

Moreover, if future short-term interest rates will be lower than current long-term interest rates then people can achieve a higher return than the current yield even without borrowing to engage in arbitrage trade. This is because as long-term securities approaches its expiration date then they will in effect become short-term securities.

Take the example of a 2-year Note which yields 4%. If a year after it was issued yields on 1-year Bills are 2%, then the people who bought the 2-year Note -who is now in effect a 1-year Bill- can sell it for a 2% higher price and they will then have achieved a 6% return. And of course the longer the maturity the greater will the potential capital gains become. If the yield on a 10-year Note falls from 4% to 2% (hardly inconceivable as long-term yields in Japan is just roughly 1.2%) then this will produce a 20% price increase.

So, if investors expect the loose monetary policy to be a more or less permanent phenonema then long-term securities will generate high returns even at these historically low yields. And given how low interest rates were pushed down during this interest rate cycle, many people have come to expect that short-term interest rates will stay much lower than in the previous interest rate cycle.

If we assume the increase in short-term interest rates during this cycle will be equal to the increase during the previous cycle, when the Fed funds rate were raised from its low of 3% during the early 1990s to 6.5% in 2000, then we should expect the Fed funds rate to peak at 4.5% during this cycle when it bottomed at 1%. This of course implies a long-term average of short-term interest rates about 2%:points below the previos cycle, which also happened to be equal to the decline in long-term yields.

For many investors the high level of debt in U.S. households makes it unlikely that the Fed would dare increase interest rates even more. Similarly, the sluggish growth and/or high debt burden in other rich countries have also increased expectations of continued low short-term interest rates there.

Of course, to the extent that low bond yields are a result of expectations of money supply increases rather than actual increases it will not cause a lowering of the overall cost of capital, but will mean a shift in investments from stocks and by extension business investments to fixed-income securities and by extension housing construction.

In conclusion, the explanation of the low yield on U.S. government securities is neither expectations of low inflation or falling global time preferences ("global savings glut"), but money-pumping by the Fed and other central banks and speculation in continued high levels of money-pumping.

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Stefan M.I. Karlsson (email) is an economist currently working in Sweden. Comment on this article on the Mises Economics Blog. See also his archive.