In Reflections on the Yield Curve and Monetary Policy, a speech before the Economic Club of New York on March 20, 2006 Bernanke listed four reasons “why the net demand for long-term issues may have increased, lowering the term premium”. Let’s take a look:
- First, longer-maturity obligations may be more attractive because of more stable inflation, better-anchored inflation expectations, and a reduction in economic volatility more generally. With the benefit of hindsight, we now recognize that an important change occurred in the U.S. economy (and, indeed, in other major industrial economies as well) sometime in the mid-1980s. Since that time, the volatilities of both real GDP growth and inflation have declined significantly, a phenomenon that economists have dubbed the “Great Moderation.” I have argued elsewhere that improved monetary policies, which stabilized inflation and better anchored inflation expectations, are an important reason for this positive development; no doubt, structural changes in the economy such as deregulation, improved inventory control methods, and better risk-sharing in financial markets also contributed.
- A second possible explanation of the evident decline in the term premium is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. According to this explanation, foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in U.S. Treasuries and closely substitutable securities, and these demands by the official sector have put downward pressure on yields. This interpretation has some support, including research that I did with two coauthors that found that longer-term yields came under significant downward pressure during episodes of heavy official purchases of dollars in 2004. However, these observations speak more to the existence of a short-term impact of large purchases and sales–the result of limits to liquidity in the very short run–than to the perhaps more important question of whether those transactions have a lasting effect on yields. On this latter issue, clear evidence is harder to come by. Several pieces of indirect evidence suggest that the long-term effect of foreign purchases on yields may be moderate. Notably, the global market for dollar-denominated bonds is enormous–perhaps around $25 trillion, including dollar-denominated debt issued by other countries as well as debt issued abroad by U.S. residents. In the long run, therefore, the market should be able to absorb purchases and sales of large absolute magnitude with relatively modest changes in yields. Indeed, long-term yields continued to fall over recent quarters even as foreign official holdings of Treasury securities increased at a slower pace than previously.
- Changes in the management of and accounting for pension funds are a third possible source of a declining term premium. Reforms proposed in the United States, Europe, and elsewhere are widely expected to encourage pension funds to be more fully funded and to take steps to better match the duration of their assets and liabilities. Together with the increased need of aging populations in the industrial countries to prepare for retirement, these changes may have increased the demand for longer-maturity securities. We have seen little direct evidence to date of sizable pension-fund portfolio shifts toward long-duration bonds, at least in the United States. But judging from anecdotal reports, bond investors might be attaching significant odds to scenarios in which pension funds tilt the composition of their portfolios toward such assets substantially over time.
- Fourth and finally, as investors’ demands for long-duration securities may have increased over the past few years, the supply of such securities seems not to have kept pace. The average maturity of outstanding Treasury debt, for example, has dropped by 1‑1/2 years since its peak in 2001, a trend just now beginning to turn with the Treasury’s reissuance of the thirty-year bond. Corporations and households, however, have taken advantage of low long-term rates to lengthen the duration of their debt in recent years, which has compensated to some extent for the reduced duration of available Treasury debt.
The Natural Interest Rate
Although it is possible that some of the above played small roles in what has transpired, Bernanke failed to list the most likely explanation for declining long term yields in the face of 15 consecutive hikes: This economy is ready to roll over and all it will take for that to happen is a prolonged housing slump. In all liklihood, the long bond sees that coming in a humongous credit repudiation ceremony and is simply reacting in advance.
Bernanke even went out of his way to dismiss both the inverted yield curve and the long bond yield in a silly discussion about the “natural interest rate”:
Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons.
First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards.
Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.
Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.
An alternative perspective holds that the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run–the natural interest rate, if you will–has declined.
Paraphrasing Bernanke in 8 points:
- The slowdown in housing, even though it contributed 50% of the jobs during this recovery is irrelevant.
- There will be no lagging effect due to 15 consecutive rates hikes (counting March).
- Unlike Spring of 2000, complacency, merger mania, and stock buybacks no longer matter. Instead they are a sign of strength.
- Rising foreclosures and bankruptcies are not really a sign of stress.
- The trade deficit is really a sign of a global savings glut. Everyone, everywhere should spend more than they make. We can, so can everyone else. It’s the proverbial “free lunch”.
- Because of the brilliancy of the Fed, the natural interest rate has declined.
- The Fed is omnipotent against any and all financial obstacles. There is no problem the Fed can not print its way out of.
- The yield curve and the action of the long bond are simply wrong.
Paraphrasing Bernanke in a single sentence:
It’s different this time!
Mike Shedlock / Mish/