Why have long rates fallen as the Fed has raised short rates? The answer I believe is Peter Warburton’s theory of financial asset inflation. Structural changes in financial markets have succeeded in funelling inflation into financial assets rather than the CPI. As the Fed expands money supply, much of the money created goes into the long bond market.
Roger C. Altman writing in the Wall St. Journal (paid - $) considers other explanations for this phenomonon and finds them wanting. In the end, he concludes,
The third explanation involves the so-called savings glut outside the U.S. While America is running big international deficits, much of the world is incurring surpluses. It is not uncommon for mature economies like Japan, Switzerland and Taiwan to run such surpluses. Their aging populations save at high rates and their slow economies don’t offer proportionate investment opportunities. What is uncommon is for developing regions to run positive international accounts. Historically, they have grown rapidly and consumed foreign capital on a net basis. But today the opposite is true.
Remarkably, Latin America, China, Africa and the Middle East are in surplus, as shown in the chart nearby. By definition, such unprecedented foreign liquidity must be invested, and more of such capital usually flows into fixed income instruments than equities. Believe it or not, comparable rates outside the U.S. are even lower than ours. Economic growth is so anemic in Europe and Japan, for example, that the yield on Japan’s 10-year government bond is 1.3%, while the 10-year German Bund is at 3.3%. At the margin, therefore, the highest returns are realized on American bonds. That is why this excess foreign liquidity has nowhere else to go.
Richard Duncan, author of The Dollar Crisis gives a similar explanation. As dollars accumulated by nations with a trade surplus relative to the US accumulate dollars, they are funneled back into the US bond market.
