VOL. 3, NO. 2 FEBRUARY 2008­­ EconomicLetter Insights from the FEDERAL RESERVE BANK OF Dallas Accounting For the Bond-Yield Conundrum by Tao Wu Long-term interest rates tend to rise as monetary policymakers increase This conundrum has short-term interest rates. This relationship didn’t hold, however, during the recent prompted a great deal of U.S. monetary policy tightening cycle. Between June 2004 and June 2006, the Fed- discussion regarding both eral Open Market Committee increased the federal funds rate 17 times—going its magnitude and the from 1 percent to 5.25 percent. Yet, long-term interest rates declined or stayed flat factors behind it. However, until early 2006. a compelling and broadly This divergence between short- and long-term interest rates caught many accepted explanation has economists, investors and central bankers by surprise. In his Feb. 16, 2005, con- yet to be reached. gressional testimony, former Federal Reserve Chairman Alan Greenspan charac- terized the behavior of long-term interest rates since June 2004: “For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.” Since then, this conundrum has tinctly different pattern. During the 12 prompted a great deal of discussion months following the initial federal regarding both its magnitude and the funds rate increase, this long-term factors behind it. However, a compel- bond yield declined by about 80 basis ling and broadly accepted explanation points as short-term rates rose rap- has yet to be reached. idly. Based on past performance, the The correct understanding and 10-year bond yield seemed to be off Based on past quantification of the conundrum have track in mid-2005, possibly by 130 direct implications for monetary policy, basis points or more. performance, the which largely impacts economies as Such a decline appeared even long-term interest rates respond to more puzzling in light of other pres- 10-year bond changes in central banks’ target rates. sures in the economy, such as a robust Persistent changes in the relationship expansion, rising energy prices and a yield seemed between short- and long-term interest falling federal fiscal deficit. All had put rates will affect the timing and impact upward pressure on long-term interest to be off track of monetary policy actions. rates in the past. Some analysts have suggested the in mid-2005, The Conundrum Period conundrum occurred because the bond During the previous three mone- market expected very rapid federal possibly by 130 tary policy tightening cycles—1988–89, funds rate increases at the beginning of 1994–95 and 1999–2000—the 10-year the tightening. When the Federal Open basis points or more. Treasury yield responded to increases Market Committee (FOMC) instead in the federal funds rate target by ris- moved in 17 consecutive 25-basis-point ing an average 26 basis points for steps, it surprised the market from the every 100-basis-point increase in the downside and bond yields were adjust- target (Chart 1). ed downward to be consistent. In the tightening episode that This explanation, however, started June 30, 2004, however, the contradicts the general impression 10-year Treasury yield showed a dis- that U.S. monetary policy’s transpar- ency has improved considerably the past two decades. During the most recent monetary policy tightening, the Chart 1 FOMC’s actions were well anticipated. After the first increase, for example, Federal Funds Rate Target and 10-Year Treasury Yield the federal funds futures market and the Eurodollar futures market correctly anticipated almost every quarter-point Percent increase in the federal funds rate for 12 the next 12 to 18 months (Chart 2). Thus, it doesn’t seem plausible that the 10 long-term interest rate declines that fol- lowed the early-stage tightening arose 10-year Treasury rate 8 from a misperception of monetary policy intention. 6 The Usual Suspects 4 In principle, bond yields can be divided into two components. One is Federal funds rate target 2 the long-term real interest rate, which consists of an expected future real interest rate, plus a risk premium to 0 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 cover the uncertainties of its future SOURCE: Haver Analytics. changes. The other is an inflation component, which depends on the EconomicLetter 2 FEDERAL RESERVE BANK OF Dallas FEDERAL RESERVE BANK OF Dallas EconomicLetter trade surpluses, Asian central banks Chart 2 invested many of these reserves in U.S. Treasury bonds, exerting downward Monetary Policy pressure on Treasury yields (Chart 3). Tightening Was Some economists estimate such pres- Well Anticipated sures on the 10-year Treasury yield at 40 to 120 basis points. More generally, a global savings A global savings glut has Percent glut has arisen from surges in revenues 4.5 for oil and commodity exporters, the arisen from surges in 4 Eurodollar futures rapid income growth of high-saving path: June 30, 2004 3.5 East Asian households and the reduc- revenues for oil and tion in fiscal deficits by several Latin 3 American countries. These develop- commodity exporters, 2.5 ments have added to the net supply 2 Actual federal funds of loanable funds to increasingly open the rapid income growth rate target changes 1.5 world financial markets, helping hold down long-term interest rates in the of high-saving East Asian 1 Fed funds futures path: June 30, 2004 U.S. and other advanced nations. .5 Increased demand by pen- households and the 0 sion funds. Some analysts argue that June Sept. Dec. Mar. June Sept. Dec. 2004 2005 declining bond yields may partly owe reduction in fiscal Maturity to higher demand for longer-duration SOURCE: Haver Analytics. Treasury securities as a result of pro- deficits by several Latin posed corporate pension reforms. In particular, U.S. pension funds American countries. expected future inflation rate, plus a might be required to match the maturi- premium compensating investors for ties of their assets and liabilities. This the uncertainties of future inflation. concern may have encouraged them Changes in long-term bond yields to increase their holdings of longer- should reflect variations in long-term real interest rates, long-run inflation expectations or risk premiums.1 Chart 3 With this in mind, it’s worthwhile to review some changes in the econ- Foreign Official Purchases and 10-Year Treasury Yield omy and financial markets that might be relevant to the conundrum. In par- ticular, market participants have cited Ratio Percent 3 10 the following factors as lowering risk premiums, putting downward pressure 2.5 9 on long-term interest rates. 2 8 Foreign official purchases. 10-year Treasury yield Many market participants have sug- 1.5 7 gested that substantial increases in foreign official purchases of U.S. 1 6 Treasury securities in recent years .5 5 have substantially depressed long-term 2 0 4 Treasury yields. In particular, Asian Foreign official purchases/U.S. GDP central banks built up their holdings –.5 3 of foreign reserves and kept their cur- rency values low relative to the dollar –1 2 to boost exports to the U.S. ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 Faced with a rapid accumula- SOURCES: Haver Analytics; Federal Reserve Board. tion of dollar assets from record-high EconomicLetter FEDERAL RESERVE BANK OF Dallas FEDERAL RESERVE BANK OF Dallas 3 EconomicLetter duration Treasuries ahead of any regu- in the amount of interest rate risks latory changes, suppressing long-term and changes in the pricing of those Treasury yields. Some analysts also risks. It recognizes that reductions in cite U.K. pension reforms, which have risk premiums are likely a part of the been associated with unusually low conundrum. yields on British bonds. In a 2006 article, Glenn Rude- Decreased macroeconomic busch, Eric Swanson and Tao Wu uncertainty. Because long-term bond provide a good example of such yields are closely related to short-term a macro–finance approach.3 The interest rates and other macroeco- analysis is based on two different nomic fundamentals (both present and models. The first is a vector autore- expected), declines in macroeconomic gression-based model developed by uncertainty since the early 1980s may Bernanke, Vincent Reinhart and Brian Foreign official purchases have put downward pressure on long- Sack (BRS) in 2004.4 The second is term interest rates. a New Keynesian-based model that of U.S. Treasury The Great Moderation of the Rudebusch and Wu (RW) developed American business cycle, as described about the same time.5 securities, increased by Fed Chairman Ben Bernanke, has Both models incorporate impor- been linked to decreased uncertainty tant linkages between interest rates demand for Treasury about inflation, real growth and real and macroeconomic fundamentals. interest rates. They also impose the standard no- securities by pension Declines in asset price volatil- arbitrage restriction from financial ity. The deepening global integration analysis to model the variations of funds, decreased of financial markets, coupled with the term premiums across all bond maturi- introduction of new financial instru- ties and over time. However, these macroeconomic ments the past two decades, may have models have technical specifications played a role in reducing the magni- that differ in important ways, such as uncertainty and tude of economic fluctuations and miti- the short-run effect on interest rates gating their effect on long-term inves- and the economy. Analysis drawing declines in asset tors.