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If bond yields are supposed to rise and bond prices fall when economies strengthen, risky assets appreciate, currencies weaken and issuance increases, then the period since mid-2009 should have been lousy for U.S. Treasury debt. During that period domestic manufacturing has begun to expand, home prices in most markets have crept higher and unemployment claims, though still high, have slowed appreciably. Global equity indices have rallied, gold has reached a record high and the trade-weighted dollar has slumped 3.75%. Since the end of June, the Fed added over $180.3 billion to base money,1 and publically-held Treasury debt increased by $267.7 billion.2
Treasury yields have shot up, right? Wrong. The 10-year U.S. Treasury rate fell over 75 basis points from their early-June peak to a five-month low of 3.18% on October 1, 2009.3 This new conundrum requires both technical—supply and demand—and fundamental economic explanations.
Although net Federal Government borrowing totaled $3.3 trillion during the first half of 2009 (the most recent data available), total net domestic borrowing was negative $663.8 billion as household, business and financial system indebtedness declined. And because the Federal Reserve bought almost $2 trillion in debt instruments during those six months, the remaining supply for other investors, foreign and domestic, actually declined, keeping interest rates in check. As the Treasury continues to auction debt at a furious pace, and do so successfully, the mix of public and private, foreign and domestic demand is keeping rates in check—so far.
Fundamentally, interest rates find a level that incorporates expected return on capital, expected inflation over the term of the debt and some measure of uncertainty about what to expect in the future. As I’ve argued in this cyberspace before, the emerging U.S. economic recovery and eventual expansion will likely produce tepid growth, lingering unemployment and modest pressure on the fundamentals that drive real interest rates. And given that weakness and the resulting slack in the economy, I think the market is correct in minimizing the medium-term risk on inflation.
Concerns about inflation, however, increase the uncertainty even among policymakers themselves, about the course of Federal Reserve policy. A reviving economy will lead the Fed to raise rates and reduce its balance sheet; the question is when, and Fed officials have publicly disagreed about the first move imminence. As the Fed tightens, policy rates should rise along the yield curve. If they do it in time to control fear of inflation, the rise will be moderate. If they appear to be chasing an escaped inflation genie, rates will rise more sharply. The market, appropriately in my opinion, is giving them the benefit of the doubt and accepting low rates, but investors will need to watch closely over the next year.
by Dr. Jerry Webman, Ph.D., CFA - OppenheimerFunds, Inc.
These views represent the opinions of the Chief Economist of OppenheimerFunds, Inc. and are not intended topredict or depict performance of any investment. These views are as of the opening of business on Friday October 16, 2009 and are subject to change based on subsequent developments. This material is not intended as investment advice.
1Source of data: Federal Reserve Board as of October 9, 2009. Data represents the aggregate reserves of depository institutions and the monetary base.
2Source of data: U.S. Department of Treasury as of August 31, 2009.
3Source of data: Bloomberg as of October 9, 2009. |
