An old academic theory links interest rates to inflation and growth, and that connection seemed durable for some time. In past business cycles, periods of high inflation and rapid expansion led investors to demand a high rate of return. When the economy grew slowly and prices held stable, interest rates fell as competition for capital declined.
Since 2000, however, the real yield on the 10-year Treasury—which is often seen as a proxy for the true long-term interest rate—has persistently fallen short of the real rate of economic growth. The theory tells us the 10-year yield should rest between 4 and 5 percent today, far above its current 3 percent. The link between growth and interest rates still exists, but there are external forces combining to keep yields soft throughout the expansion.
Over the past decade, investors’ expectations for inflation have aligned closely with the actual behavior of prices, so today’s relatively low real yields cannot be attributed to an unforeseen bout of inflation catching the market off guard. Bond investors currently anticipate inflation to hold near the Federal Reserve’s 2 percent target over the long run, leaving a very low real return. The 10-year Treasury Inflation Protected Securities yield is currently less than 1 percent, yet real GDP growth sits near 2 percent with the potential to accelerate to 3 percent in the fall. It seems curious, then, that bond investors are settling for so little.
Treasury yields may be historically low, but they exceed the yield on German bunds by more than 2 percentage points—a historically wide margin. For global investors seeking safe returns, US government debt is much more attractive than the bonds issued in Europe or Japan, where quantitative easing programs are intentionally suppressing yields. The Fed may have tapered its own asset-purchasing program, but the US bond market is likely being skewed by the actions of central banks abroad.
This distortion should eventually fade. The European Central Bank plans to gradually wind down its quantitative easing program this year, which will allow yields to rise to their natural equilibrium. But tapering will unfold over a long period, and the US advantage in yields will likely persist for some time.
Developing economies naturally run trade surpluses; to keep their exchange rates stable, foreign governments often park their surplus dollars in US Treasurys. This keeps East Asia’s export-focused manufacturing sectors competitive on the global market, but the influx of foreign capital also tends to drive Treasury yields lower.
Trade imbalances are the natural consequence of rapid growth in industrializing nations, a trend that shows no sign of slowing. Dollarization should begin to ebb as a new consumer class emerges throughout the developing world, but this shift in capital flows is likely to evolve over decades.
The Fed is shrinking its balance sheet, but new banking regulations have increased liquid capital holding requirements for large financial institutions. This means that as the Fed sells off the excess holdings acquired through quantitative easing, demand from private banks likely will increase.
This is one reason for the relative stability of yields as balance sheet normalization begins. The Fed is currently allowing $30 billion in Treasurys and other long-term securities to mature every month, with the pace of the runoff set to accelerate to $50 billion monthly later this year. Much of the new debt entering the market is being bought up by financial firms, which are required to maintain a large buffer of stable, liquid assets as a backstop against volatility. Since Treasurys are ideal for meeting this requirement, banks will likely continue to buy them even when yields are below their natural equilibrium.
Long-term bond yields—and by extension, interest rates—may be resting well below their natural equilibrium. If inflation holds near the Fed’s 2 percent target and real growth averages between 2 and 3 percent annually, nominal yields should tend to rise toward 4 percent. The link between interest rates, growth and inflation has not broken, but the forces skewing the bond market are persistent. Yields are likely to evolve over the course of years or even decades as they seek their natural equilibrium.
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