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The interest rates mystery

  When the Federal Reserve began the restrictive trend in its monetary policy in June 2004 the yield on US 10-year Treasury bonds stood at 4.6%. Since then, the Fed’s reference rate has risen from 1% to 3.75%, that is to say, it has shown an incresae of 275 basis points. Now, in the third week of October 2005 the yield on US Treasury bonds stood at 4.5%, slightly below the rate at the beginning of the contractile move in monetary policy. This is anomalous, seeing that normally long-term interest rates go up when short-term interest rates begin to rise. The chairman of the Federal Reesrve Board, Alan Greenspan, himself admitted that the performance of long-term bonds was an enigma. In the euro area, long-term government bond interest rates stand at still lower levels with German bonds going to their lowest level in recent decades in the fourth week of September.

  What is the explanation of this strange development? It should be remembered that, following the oil shocks in the Seventies, government bond yields rose strongly as may be seen in the accompanying graph. The central banks had to work their hardest in order to break the inflationary prospects of the Eighties through restrictive monetary policies. Thanks to the disinflationary process in the Eighties and Nineties, inflation rates fell to very low levels (see graph) and the central banks gained in credibility, something that increased as they took on greater independence.

  Evidently, this is a factor that has contributed to maintenance of bond yields at low levels in order to contain inflation prospects and to lower the inflation risk premium by reducing uncertainty about the future trend in prices. But this alone does not fully explain the present low levels. Another reason lies in the fact that in recent years there has been a sharp increase in international foreign reserves, especially on the part of Asian countries with currencies linked to the dollar. A good part of these reserves are held in US Treasury bonds. Heavy buying of US bonds by Asian central banks has contributed to depress yields on these securities. In addition, there seems to be excessive world savings in relation to investment demand which could serve to push down long-term interest rates.

  No doubt, an important factor is to be found in inflation prospects. Measured by the difference in nominal bond yields and those indexed to inflation, these prospects would appear to be contained, although they are recently tending to show a moderate rise. One factor contributing significantly to the holding down of inflation is the increase in world competition and imports from low labour-cost countries. In any case, this excessive liquidity has brought about a sharp rise in some real assets, such as housing.

  On the other hand, in recent years institutional investors, such as pension funds and insurance companies, have tended to increase the share of their portfolios held in bonds so that demand has increased, bond prices have tended to rise and, as a result, their yields, which move in the opposite direction to prices, have tended to drop.

  Although it now seems that the downward trend in bond yields has stopped, we may ask which of the factors mentioned really bring about a change in trend. Oil prices probably will tend to rise in coming years because of structural problems which may have an effect on inflation prospects. The excess in savings may also be redirected once demand for investment increases with economic recovery. Nevertheless, the other factors would seem to be more permanent. Because of this, our forecasts are for a moderate rise in bond yields, but naturally not reaching the levels seen in the Eighties. In any case, the performance of bonds will remain a mystery.

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