On Rates, Part I: Why Are They So Low?

Submitted by Rich Toscano on July 9, 2005 - 9:55pm
It is counterintuitive that US long-term interest rates have remained so low in the face of Fed rate hikes, record low household savings, record high trade and fiscal deficits, steeply rising energy and commodity prices, and unprecedented home equity-related wealth creation. This article discusses five factors that have interacted to help keep rates so low in spite of the above.
  1. An extremely low Federal funds rate
  2. Foreign central bank currency intervention
  3. Private foreign investment in US bonds
  4. Expectations of low future consumer price inflation
  5. Expectations of an economic slowdown

A (Very) Brief Bond Primer

It might be helpful to begin with some basic points about bonds. Those familiar with what bonds are all about may wish to skip to the next section.

A bond is simply a promise to pay a certain amount of money in the future. The purchaser of a bond is in effect lending money to the seller of the bond. Like all prices, bond prices are dependent on supply and demand: the price someone is willing to pay for a bond is dependent on how many people want to borrow money (bond supply) and how many want to lend it (bond demand).

As the price of a bond rises, the effective yield that the bond purchaser will receive declines, and vice-versa. Therefore, an increase in demand for bonds (the willingness to lend money) will result in an increase in the price of bonds and thus a decline in bond yields. For the purposes of this article we will refer to yields (or rates, which are the same thing) as yields are what we are interested in.

Short-term bond rates are heavily influenced by the actions of central banks, who artificially create demand or supply in order to achieve their desired target rates. Long-term rates (or demand for long-term bonds) are partially based on expectations of future short-term rates but are influenced by other factors as well. For instance, the expectation of high future inflation reduces demand for bonds, thus pushing up yields, as higher inflation will make future bond income worth less. Similarly, the risk of "default" (i.e. that the borrower will not pay back the loan) causes yields to rise or fall based on the creditworthiness of the borrower.

If you'd like to know more, I highly recommend the Bond Basics, a less-brief overview from the smart folks at bond investment firm PIMCO.

The Fed Funds Rate

In an attempt to stimulate the economy in the aftermath of the stock bubble burst, the Federal Reserve began lowering its target rate in 2001 and didn't stop until it hit 1% in mid-2003. 1% was incredibly low—the lowest that the Fed funds rate had been since the 1950s—and significantly lower than the rate of inflation. Because long-term rates are based partly on the expectation of future short-term rates, the Fed's aggressive lowering of the short-term rate put downward pressure on long-term rates. But such excessively low short rates (significantly lower even than the rate of inflation) also helped lower long rates by way of "the carry trade."

The carry trade refers to the act of borrowing money at short-term rates, lending that money at long-term rates, and pocketing the difference. For example, a bank might take the money in a bank account (for which it was paying 1% interest) and lend that money out as a 30-year mortgage at 4%, leaving them a 3% profit. The carry trade, which became quite a cash-cow for financial institutions and hedge funds, had the effect of increasing the demand to lend money long-term. It thus helped to reduce long-term rates.

The Fed has since hiked its rate up to over 3%, so it isn't stimulating long-term lending the way it used to. However, it's important to keep in mind that the Fed Funds Rate is still quite low—it was only recently that the Fed rate made its way above the rate of consumer price inflation. Given that long rates are based on expectations of future short rates, the Fed's promise of "measured" increases has further helped to keep a lid on long rates. And while the carry trade has died down somewhat, it is still employed by many hedge funds, who have simply increased their leverage to amplify the returns earned on an ever-shrinking spread between short and long rates.

Foreign Central Banks

The amount of US debt purchased by foreign central banks over the last few years has provided significant downward pressure on yields. My article on the origins of the bubble describes how currency intervention efforts by foreign (primarily Asian) central banks increased the demand for US bonds:

What was happening was that the export-heavy Asian economies were going to great lengths to keep their currencies low against the dollar, thus keeping their products cheap for Americans to buy. The primary mechanism for this currency intervention was as follows, using Japan as an example: Japan would receive into its banking system US dollars which came from Americans who were buying Japanese products. The Bank of Japan did not want to sell these dollars in exchange for yen, because doing so would add to the supply of dollars for sale and add to the demand for yen, effectively strengthening the yen against the dollar and driving up dollar-denominated prices for Japanese goods. So they kept their money in US dollars by using it to buy US financial assets, primarily Treasuries and other debt instruments, thus avoiding weakening the dollar.

I'm not really going to throw a lot of facts and figures at you, because (unlike the San Diego real estate stats that I dwell upon) foreign central bank purchases of US debt have been widely discussed and documented in the financial media. However, just to give you a flavor of the extent of central bank efforts, I will quote a quick passage from economist Richard Duncan describing one of the more egregious episodes of currency intervention:

In the 15 months ended March 2004, the BOJ [Japanese Central Bank] created ¥35 trillion which the MOF [Japanese Ministry of Finance] used to buy $320 billion, an amount large enough to fund 77% of the US budget deficit in the fiscal year ending September 30, 2004. It is not certain how much of the $320 billion the MOF did invest into US Treasury bonds, but judging by their past behavior it is fair to assume that it was the vast majority of that amount.

In short, foreign central banks have spent the last few years lending a lot of money to the US. The resultant increase in demand for US bonds has helped to drive down yields, in addition to setting the stage for the influx of foreign private investment discussed next.

Foreign Private Investors

Quoting once again from A Bubble Primer 3:

The Asian central banks' heroic efforts to keep their currencies weak against the dollar, combined with their own incredibly low short-term rates, also encouraged their own private investors to buy US debt instruments.

Using Japan as an example, again: a Japanese saver (and there are a lot of them—unlike here in the US, there is a huge cultural prerogative to save money in Asia) would be looking around for a place to invest money. Japanese government bonds would be yielding between 1% and 2%. US Treasuries would be yielding around 4%—not great, but better than Japanese bonds. And due to Japanese central bank's obvious commitment to keeping their currency weak against the dollar, there was little chance for the private investor to lose money via currency exchange rates. The choice was obvious: buy dollar-denominated bonds.

So all those thrifty foreigners could get some extra yield by buying US bonds. And they didn't have to worry about the dollar falling against their own currencies, because they knew their governments wouldn't let that happen. In addition to all the central bank buying, then, we had foreign private investors piling into long-term bonds as well, pushing long rates even lower.

Low Inflation Fears

China's emergence as a manufacturing powerhouse and the ability for American firms to utilize low-cost foreign labor have combined to exert tremendous downward pressure on consumer goods prices. Companies simply can't raise prices, because if they do, the ever-increasing trend towards globalization and offshoring ensures that someone else will undercut them.

This dynamic has significantly lowered expectations of future consumer goods price inflation. And a low "inflation premium" due to confidence that the dollar will maintain its purchasing power translates to lower yields for US bonds.

An Impending Slowdown?

The continued decline of long rates even as the Fed has hiked rates for the past year has prompted many observers to speculate that expectations of an economic slowdown or even a recession are priced in to current bond yields.

There is some evidence pointing to a slowdown in economic growth—the Conference Board's index of leading economic indicators, to name one example, has dropped for four of the past five months. And a slowing economy would naturally lower bond yields, as people fled from stocks to bonds and bond investors priced in expectations of lower inflation and another Fed rate-cutting campaign.

Whether this is another "soft patch" or something more ominous remains to be seen. However, there is little doubt that the threat of a slowdown is currently adding to downward pressure on rates.

Interactions

Many of the bond market influences described above reinforce one another. For instance, foreign investors would not be so emboldened to invest in dollar-denominated debt if their governments weren't trying so hard to prop up the dollar. Similarly, a fall in the dollar against the currencies of our major trading partners would result in increased import prices and thus increased inflation.

It's quite the virtuous cycle, for now, and bond yields will continue to remain low as long as all these factors remain in place. But how long will they remain in place?

Part 2 of this article will explore what might happen to upset this delicate balance and cause bond yields—and thus mortgage rates—to rise.

(category: )