Markets not moving interest rates to correct global imbalance
Low interest rates are increasingly recognised as a worldwide phenomenon. There have been several reasons advanced for the low rates -- global savings glut, weak global economy -- to which another reason has been added: the failure of capital markets.
A recent purveyor of this view is The Economist. On 18 August, it wrote the following in an article on its website:
The Economist argued that countries with current account or budget deficits should face higher yields to compensate investors for the higher risk of a currency depreciation. However, using the case of the United States, which suffers from both a current account as well as a budget deficit, this has not happened. The Economist attributed the failure of bond yields to rise to Asian central banks buying US Treasury bonds to prevent their currencies rising and to cheap goods from emerging economies keeping inflation down and resulting in central banks holding interest rates down as well.
The Economist further argued that the liberalisation of international capital flows should have enabled markets to "punish economies where governments or households borrow recklessly with higher bond yields, prompting them to tighten their belts". However, this does not appear to have happened.
This is not really surprising. As I said in my previous article concerning the diminishing US personal saving rate (see "US saving deficit leads to trade deficit"), deficits that appear unsustainable over the long term can still last for a considerable period of time.
While the market will very probably eventually move to a sustainable equilibrium, the timing of such a move is always highly uncertain. Remember that Federal Reserve chairman Alan Greenspan declared that there was "irrational exuberance" in the stock market as early as 1996. The US stock market bubble, however, did not burst until four years later. Even today, US stock market indices remain above their levels in 1996.
Therefore, with ample capital inflows at the moment, countries like the United States can sustain their deficits and maintain low interest rates at the same time for quite a while more.
Certainly, as The Economist pointed out, central banks play an important role in keeping interest rates low. That includes the Federal Reserve. In fact, by keeping the federal funds rate substantially below the inflation rate until recently, the Federal Reserve has played a key role in keeping long-term bond yields low.
There is no secret to this phenomenon. The federal funds rate directly affects the cost of short-term funds, that is, short-term interest rates. The cost of short-term funds obviously affects the cost of long-term funds, that is, long-term interest rates. When short rates fall far below long rates, arbitrageurs swoop in, borrowing at the short rate and lending at the long rate, which tends to close the gap and push the long rate down.
When the Federal Reserve started its interest rate hikes in June last year, the spread between the 10-year Treasury note and the federal funds rate was well over 300 basis points. That is far above its average over the previous 50 years of below 100 basis points. Such a spread might be sustainable in a powerfully-expanding economy, but not at the mature stage of the cycle that the economy is now in where growth is expected to moderate.
The spread has since fallen, partly due to a rise in the federal funds rate, but partly also due to a fall in the 10-year yield as the outlook for economic growth moderated (see "Outlook for stocks and bonds may depend on PMI").
Alan Greenspan has called the fall in long-term rates a "conundrum". But it is partly of his own making. The slow or -- in the Federal Reserve's own words -- measured pace of rate hikes has surely been a factor. A slow rate of Federal Reserve hikes in the presence of a large spread between the 10-year yield and the federal funds rate has historically not been conducive to increases in the former.
The following chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis).
From the above chart, it can be seen that, over the course of a year, when the increase in the federal funds rate has fallen well short of the spread (reflected as a data point well to the left side of the chart), the 10-year yield has often fallen in that year. In other words, if the federal funds rate cannot come up to the 10-year yield, the 10-year yield will come down to it.
Since the start of its rate hikes a little over a year ago, the Federal Reserve has raised the target federal funds rate by 250 basis points, well short of the spread at the beginning of its rate hikes. Little wonder that long-term rates have fallen.
However, with the spread between the 10-year yield and the federal funds rate now at about 70 basis points, a few more rate hikes by the Federal Reserve should see the former finally start to respond in the desired direction -- that is, up. Unless, of course, the economy weakens more than expected.
In any case, the upshot of this is that while the market may not be doing a very good job at moving interest rates in the direction required to correct long-term global imbalances, its behaviour has not, in fact, been very different from its historical pattern.
(Update on 13 February 2006: Corrects error on the spread at the start of interest rate hikes.)
A recent purveyor of this view is The Economist. On 18 August, it wrote the following in an article on its website:
The world currently displays an alarming number of large economic and financial imbalances. America's current-account deficit is forecast to widen to over $800 billion this year, while Germany, Japan and China look set to run record surpluses. Total government debt in rich economies has risen to a new high as a percentage of GDP, and in many countries households are sliding ever further into debt. Meanwhile, the growth rates of America and other rich economies have diverged to an unusual degree.
Many economists try to explain these trends in terms of underlying structural factors, such as differences in demographic trends or productivity growth. An alternative, more worrying, explanation is that the price signals that are supposed to bring the world economy back into balance have become distorted.
The Economist argued that countries with current account or budget deficits should face higher yields to compensate investors for the higher risk of a currency depreciation. However, using the case of the United States, which suffers from both a current account as well as a budget deficit, this has not happened. The Economist attributed the failure of bond yields to rise to Asian central banks buying US Treasury bonds to prevent their currencies rising and to cheap goods from emerging economies keeping inflation down and resulting in central banks holding interest rates down as well.
The Economist further argued that the liberalisation of international capital flows should have enabled markets to "punish economies where governments or households borrow recklessly with higher bond yields, prompting them to tighten their belts". However, this does not appear to have happened.
This is not really surprising. As I said in my previous article concerning the diminishing US personal saving rate (see "US saving deficit leads to trade deficit"), deficits that appear unsustainable over the long term can still last for a considerable period of time.
While the market will very probably eventually move to a sustainable equilibrium, the timing of such a move is always highly uncertain. Remember that Federal Reserve chairman Alan Greenspan declared that there was "irrational exuberance" in the stock market as early as 1996. The US stock market bubble, however, did not burst until four years later. Even today, US stock market indices remain above their levels in 1996.
Therefore, with ample capital inflows at the moment, countries like the United States can sustain their deficits and maintain low interest rates at the same time for quite a while more.
Certainly, as The Economist pointed out, central banks play an important role in keeping interest rates low. That includes the Federal Reserve. In fact, by keeping the federal funds rate substantially below the inflation rate until recently, the Federal Reserve has played a key role in keeping long-term bond yields low.
There is no secret to this phenomenon. The federal funds rate directly affects the cost of short-term funds, that is, short-term interest rates. The cost of short-term funds obviously affects the cost of long-term funds, that is, long-term interest rates. When short rates fall far below long rates, arbitrageurs swoop in, borrowing at the short rate and lending at the long rate, which tends to close the gap and push the long rate down.
When the Federal Reserve started its interest rate hikes in June last year, the spread between the 10-year Treasury note and the federal funds rate was well over 300 basis points. That is far above its average over the previous 50 years of below 100 basis points. Such a spread might be sustainable in a powerfully-expanding economy, but not at the mature stage of the cycle that the economy is now in where growth is expected to moderate.
The spread has since fallen, partly due to a rise in the federal funds rate, but partly also due to a fall in the 10-year yield as the outlook for economic growth moderated (see "Outlook for stocks and bonds may depend on PMI").
Alan Greenspan has called the fall in long-term rates a "conundrum". But it is partly of his own making. The slow or -- in the Federal Reserve's own words -- measured pace of rate hikes has surely been a factor. A slow rate of Federal Reserve hikes in the presence of a large spread between the 10-year yield and the federal funds rate has historically not been conducive to increases in the former.
The following chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis).
From the above chart, it can be seen that, over the course of a year, when the increase in the federal funds rate has fallen well short of the spread (reflected as a data point well to the left side of the chart), the 10-year yield has often fallen in that year. In other words, if the federal funds rate cannot come up to the 10-year yield, the 10-year yield will come down to it.
Since the start of its rate hikes a little over a year ago, the Federal Reserve has raised the target federal funds rate by 250 basis points, well short of the spread at the beginning of its rate hikes. Little wonder that long-term rates have fallen.
However, with the spread between the 10-year yield and the federal funds rate now at about 70 basis points, a few more rate hikes by the Federal Reserve should see the former finally start to respond in the desired direction -- that is, up. Unless, of course, the economy weakens more than expected.
In any case, the upshot of this is that while the market may not be doing a very good job at moving interest rates in the direction required to correct long-term global imbalances, its behaviour has not, in fact, been very different from its historical pattern.
(Update on 13 February 2006: Corrects error on the spread at the start of interest rate hikes.)
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