Markets and Economy
What’s Holding Down Yields?
Despite a consistently strengthening economy, 10-year Treasury yields have risen very little over the past year. Global crosscurrents, regulatory changes and trade imbalances may all be contributing to lower yields.
Treasury yields should rise as the economy gains momentum—but with the peak of the business cycle approaching and interest rate normalization well underway, yields are currently resting well below their projected long-term equilibrium.
Equity investors clearly have confidence in future earnings and businesses are adding staff rapidly to meet rising consumer demand, but bond investors seem content with yields that barely exceed inflation expectations. Why isn’t the market demanding more?
Rising in Theory
Long-term Treasury yields are often assumed to reflect the natural equilibrium interest rate. When the economy is in recession, yields should fall as investors see relatively few opportunities in the private sector. But during periods of expansion, yields are expected to rise as the economy’s growth potential increases and inflationary pressure builds. The yawning federal deficit would also be expected to push yields higher, as government debt may begin to compete with the private sector for capital in the coming decades.
But instead of steadily climbing as the economy improves, bond markets have been relatively tranquil. The term premium on Treasurys—investors’ expected return above inflation—has been negligible to negative since the 2008 downturn. Even after January’s half-point rally, the 10-year yield still rests less than one percentage point above the Fed’s long-term inflation target.
Flaws in the Pessimistic Interpretation
Some analysts believe that low yields reveal a pessimistic consensus about potential growth. Official forecasts may call for inflation rising to 2 percent and GDP expansion lifting off, but bond traders appear cautious. If the market believes that growth has permanently downshifted, then lower real interest rates would be one sign that we have entered a new era of secular stagnation.
There are two major problems with this theory. First, it’s highly unlikely that bond investors and equity investors hold diametrically opposed economic outlooks. Stock valuations reflect optimism, pricing in a healthy expansion in corporate revenues for the foreseeable future. Second, even if the US is destined to suffer from demographic shifts in the labor market and sluggish productivity growth, bond markets are global. Investors could easily move their funds to a higher-growth market in the developing world, where industrialization and urbanization are generating rapid economic expansion. The fact that investors aren’t turning to foreign bond markets suggests there are other forces at work.
4 Reasons Bond Yields Are Low
- Quantitative easing: During the early years of the recovery, the Federal Reserve engaged in a massive asset-purchasing program, buying up trillions of dollars of Treasurys in a successful attempt to drive down borrowing costs and stimulate growth. Now that the Fed is normalizing its balance sheet, yields are floating more freely on the domestic market. However, central banks abroad are still engaged in asset-purchasing programs of their own. The market for US, eurozone and Japanese government debt overlaps considerably, so intervention abroad is likely skewing US yields down.
- Regulatory requirements: In the aftermath of the 2008 financial crisis, new banking regulations increased the liquid cash requirement (LCR) that large banks must hold in reserve. Since Treasurys are stable in value and easily sold on the market, they are the ideal instrument for meeting the LCR. As the economy expands, banks’ assets are growing, pushing their LCR obligations higher. This increased demand for Treasurys from the financial sector may be another factor keeping yields low.
- Global trade imbalances: Developing nations with large export-based manufacturing sectors naturally run trade surpluses. Many of these countries choose to reinvest their accumulated dollars in Treasurys and other dollar-denominated assets in order to keep currency markets stable. As consumer demand rises in the US, the trade deficit in merchandise is expected to widen, and the volume of foreign money flowing back into Treasurys will continue to grow. The rising global savings rate should contribute to lower long-term interest rates, tempering the rise of Treasury yields.
- Accelerating growth: Recently passed tax legislation may spur faster productivity growth over the coming years by incentivizing investment in labor-enhancing technologies like automation. Even a modest acceleration in growth would dramatically reduce the volume of debt the Treasury will need to issue in future decades. If fewer Treasurys are coming onto the market, yields should sag.
The bond conundrum has been with us since the late 1990s, when Alan Greenspan first began puzzling over why yields were rising so slowly in the face of robust growth. The forces that are tempering yields have proven durable, and there is no reason to believe they will dissipate at the peak of the current business cycle.
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Jim Glassman, Head Economist, Commercial Banking
Jim Glassman, Head Economist, Commercial Banking
Jim Glassman is the Managing Director and Head Economist for Commercial Banking. From regulations and technology to globalization and consumer habits, Jim's insights are used by companies and industries to help them better understand the changing economy and its impact on their businesses.