Explaining the fall in bond yields

4 October 2004

In the wake of three hikes in the federal funds rate by the Federal Reserve, yields on 10-year Treasuries have fallen in the United States, much to the surprise of many economists. Many economists have been searching for an explanation for this divergence, but in a globalised economy, the search for an explanation needs to be global as well.

The divergence between the federal funds rate and 10-year yields had become obvious by 21 September, when the Federal Reserve raised the federal funds rate to 1.75 percent, the third increase since June this year. Over roughly the same period, US 10-year Treasury bond yields, which had hit a high of about 4.9 percent in June, fell to 4 percent.

Since the federal funds rate normally underpins all other interest rates, many economists have wondered why yields for 10-year Treasuries have fallen in the face of rising federal funds rate.

The simple reason is that the federal funds rate affects the availability of short term funds and therefore, directly affects short term interest rates, but longer duration interest rates are affected by other factors like inflation and GDP growth.

This in turn leads to the obvious question: Are bond investors seeing low inflation or low economic growth? Recent evidence suggests both are real possibilities.

The inflation rate in the US for the year to August 2004 was 2.7 percent. However, excluding food and energy, the inflation rate is 1.7 percent.

Oil prices have risen considerably this year, with NYMEX crude oil hitting a record US$50 a barrel last week. However, the rise in oil prices have not resulted in any sustained rise in consumer prices. In fact, Avery Shenfeld, senior economist at CIBC World Markets Inc. in Toronto, suggested to Bloomberg: "If anything, high energy prices pushed core inflation lower by forcing companies to resort to discounting merchandise as consumers had to spend more to fill up their gas tanks."

High oil prices may also aggravate the economic slowdown that had started in the second quarter of this year. The economy grew at a 3.3 percent annual pace in the second quarter, slower than the 4.5 percent rate in the first three months.

That slowdown may have had a significant effect on restraining prices. "When total wages and salaries in the economy are growing slowly, consumers just don't have the spending power to cover high prices," said Shenfeld.

And despite Federal Reserve chairman Alan Greenspan's repeated comments that the economy is regaining "traction", evidence that the economy is re-accelerating is far from clear.

The Conference Board's index of leading economic indicators has declined for three consecutive months, falling by 0.3 percent in August to 115.7. In July, the index had fallen by 0.3 percent and in June, by 0.1 percent.

Last week, the Conference Board reported that its consumer confidence index for September fell to 96.8 from a revised 98.7 the previous month. The Conference Board's present situation index fell to 95.5 from 100.7 in August while the expectations index was virtually unchanged at 97.6 compared with 97.3 in August.

Indicators in manufacturing are also unclear. Durable goods orders were down 0.5 percent in August, but excluding transportation equipment, orders were up 2.3 percent. And on Friday, the index of manufacturing activity compiled from the Institute of Supply Management's survey of manufacturers' purchasing managers came in at 58.5 for September, a slight drop from the 59.0 reading in August.

And Mark Gilbert, a columnist for Bloomberg, has recently pointed out a dichotomy:

According to indexes compiled by Credit Suisse Group, the 40- basis point premium available on the most actively traded U.S. corporate bonds maturing in one to four years is the lowest in the five years the index has been in existence, and less than half its average in that period... For corporate debt of all maturities, spreads are about 90 basis points, compared with a five-year average of 144 basis points. Among Eurobonds, the current 40 basis-point spread compares with a five-year average of 70 basis points and a high of about 130 basis points reached two years ago.

If lower Treasury yields imply lower economic growth, why is the risk premium on corporate debt shrinking?

Maybe in looking for an explanation for the fall in interest rates, economists have been looking at the wrong places. Gilberts suggested: "Maybe the oft-cited Treasury buying by Asian central banks, rather than the economic outlook, is the real driver of the 10-year yield."

In a recent e-mail exchange between Morgan Stanley's chief economist Stephen Roach and Pacific Investment Management Co.'s chief investment officer William Gross -- published on 30 September in the Global Economic Forum -- the two discussed Asian central banks' role in keeping US interest rates low.

Roach wrote: "Lacking consumption growth, any currency-related hit to exports is a serious threat. So Asian central banks buy American bonds, which then support US asset markets."

Gross agreed, saying that the "Chinese and the Japanese are foolishly standing in the way [of a correction in the bond market], purchasing US Treasuries at the rate of $300 billion a year to prevent their own currencies from appreciating." He thinks that the Chinese are unpredictable and have their own domestic priorities, and would do "anything to prevent their products from losing what would still be an overwhelming pricing advantage".

Gross wrote that for bond yields to rise, the Chinese and the Japanese must play their part. "The world has changed a lot in the past decade," he wrote, "and a new pair of financial studs has displaced yours truly and others from their number one power ranking."

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