How did rates get to zero? The U.S. Treasury issued 3-month duration bonds paying o% for the first time on record on October 5, 2015, so holders lost money after fees when their principal was returned in January of this year. How did this happen? To understand why rates are low today, we need to look back to the middle of the last decade, when the disconnect first emerged between the federal funds rate and actual market yields for U.S. Treasuries. Between 2004 and 2006, measured increases pushed-up the federal funds target rate by 425 bps, but the yield on 10-year Treasuries increased by only 40 bps. The shift upwards in rate should have mirrored one another. As Alan Greenspan (2005) told Congress: “This contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in the longer-term yields.” Greenspan concluded his testimony, saying: “For the moment, the broadly unanticipated behavior of the world bond markets remains a conundrum.” Well, that is no longer the case.
What could have caused such a “conundrum” in 2005? During the same period, the U.S. Treasury market underwent a profound change, as foreign reserves held by central banks grew from $2 trillion in 2000 to $6 trillion in 2008 at the onset of the U.S. financial crisis. This ‘great accumulation’ began after the Asian Crisis in 1997, when the Bank of Thailand was forced to devalue its currency after foreign reserves proved insufficient, and was furthered when oil exporting nations recycled their outsized profits into U.S. Treasuries, during a stretch that saw oil prices increase from $10/barrel in 1999 to $145/barrel in July 2008. As countries reversed course from their role as net capital importers, foreign ownership of long term (maturity over one-year) US marketable Treasury debt increased from 19% in 1994 to 57% in 2007. This added demand lowered yields, as basic bond math would suggest. One study from University of Virginia study estimates foreign reserve accumulation created downward pressure equal to 0.8% on the yields for U.S. Treasuries, a meaningful figure when compared to the total yield of 4.2%.
Ben Bernanke (2005), then still a FOMC governor, recognized the increase in foreign demand and argued a “global savings glut” had led to growing stockpiles of bonds that had compressed interest rates. This hypothesis has since gained broad acceptance, but it describes the situation without explaining it, in our view, because Bernanke’s diagnosis treats all cross-border capital flows equally. China’s savings rate of 50% saving rate, a level unknown in capitalism outside of wartime, is understood to be indefinite. How else to explain the fact that the People’s Bank of China held 24% of total U.S. Treasury Securities (valued at $895 billion) in 2009? The figures are such that every person in China had effectively loaned $4,000 to every American at the onset of the financial crisis in 2008. In contrast to Japan, reserves cannot be interpreted as average Chinese families saving half their earnings, because profits are captured through state-owned enterprises and saved at the state level. It’s how planned economies operate. Former Treasury Secretary Lawrence Summers noted the oddity in a May 2008 interview with Harper’s, when asked why a country like China with so many unmet needs would let “this $1 trillion go to a mature, old rich place from a young, dynamic place,” saying “from a distance, this, to say the least, is strange.”
With the benefit of hindsight, Bernanke’s “savings glut” hypothesis has been reconsidered and many are beginning to make the obvious link between (i) the large amounts of foreign capital made available to low-grade U.S. borrowers and (ii) the Financial Crisis of 2008 triggered by excess mortgage lending. Subprime mortgages could only have grown from 8% of the market in 2004 to 20% in both 2005 and 2006, if there was demand for U.S. securities, albeit on faulty terms. Farooki et al (2012) highlight the “series of significant impacts on the global economy” caused by China’s recycled savings, which “have underwritten low global interest rates.” This understanding makes sense when viewed within the context of the “natural rate of interest” concept first proposed by Knut Wicksell (1898), which says distortions in the market occur when the natural rate does not reflect the average return on new capital investment. Wicksell reasoned the natural rate of interest governed the availability of credit and that the process was a self-correcting one, such that extended periods of mal-investment ultimately cause declines in productivity growth, driving lower potential output and increases in inflation. Wicksell’s view is notably distinct from the author of America’s unconventional monetary policy, Ben Bernanke (2015), who recently argued in favor of low rates by saying: “At a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the smallest amount of fuel expended by trains and cars that currently must climb steep grades.” Bernanke’s views on rates, thus, only agree with Wicksell’s natural rate, if all competition and resource constraints are eliminated and the time cost of money ignored, altogether. It’s why the monetary policy of the U.S. Federal Reserve is called unconventional.