The economy is gaining strength, but yields on Treasury notes remain stubbornly low. As the world’s safest investment, U.S. Treasury bond yields are normally pegged to expectations for interest rates and inflation. For the past six years, however, the Fed’s asset purchasing program has successfully depressed bond yields in an attempt to shift investment towards private-sector equities.
So when the Fed began tapering its asset purchases, bond yields were expected to climb back over time, especially when the Fed fully normalized the federal funds rate, into the neighborhood of 4 to 5 percent. Instead, 10-year Treasury note yields are near 2.66 percent, only 100 basis points from where they were during the Fed’s asset purchases. Why?
Some of the factors behind this gap are obvious. Inflation has been lower than most expected and low inflation has reduced pressure on yields throughout the developed world. And America’s shrinking federal deficit has led the Treasury Department to issue fewer bonds. At the same time, foreigners continue to accumulate bonds at a steady pace.
For foreign central banks, demand for U.S. government debt may be driven by political—not economic—considerations. When a nation exports more goods to the U.S. than it imports, the country’s banks develop a currency account surplus—the extra dollars with which U.S. consumers purchased their imports. Ideally, this money would find its way back to the nation’s workers, but repatriation entails political risks. To be paid as wages, the surplus dollars must first be converted into the local currency, increasing its price relative to the U.S. dollar. A stronger currency makes the nation’s exports more expensive in the U.S. and damages manufacturers’ prospects.
Not surprisingly, surplus dollars are often used to purchase U.S. Treasury Bonds instead. If surplus dollars are never converted into local currency, exchange rates will remain favorable for exporters. For foreign bankers, yields are a secondary concern—they have even been willing to accept slightly negative real returns. Demand from foreign investors has proven consistent. They spent over $30 billion in monthly bond auctions even when inflation-adjusted yields took a prolonged dive into negative territory.
Today’s low yields may defy market expectations, but they are unlikely to survive an interest rate hike. Bearish investors are currently betting against higher interest rates, but if proven wrong, they will rapidly abandon their position. Similarly, foreign officials’ institutions willingly buy U.S. bonds to promote their development ambitions. Their purchases are driven by broad economic goals, not investment returns on their portfolios.