| FRBSF Economic Letter 2005-08; April 29, 2005
The Long-term Interest Rate Conundrum: Not Unraveled Yet?
In congressional testimony on February
16, 2005, Federal Reserve Chairman Greenspan characterized
the recent behavior of long-term interest rates as a "conundrum." Typically,
long-term rates tend to rise as monetary policymakers raise
short-term rates. But not in the current episode. Despite
steady monetary tightening beginning in the middle of 2004,
the yields on long-term U.S. Treasury securities actually
have declined since then by about 50 basis points. As a
consequence, the current level of long-term interest rates
seems to be well below what one would expect on the basis
of economic fundamentals.
A number of explanations of the "conundrum" have
surfaced, and this Economic Letter will focus on one in
particular, namely, the tremendous increases in purchases
of U.S. Treasury securities by foreign central banks (especially
by those in East Asian countries). Some estimate that during
the past two years, such purchases have depressed the 10-year
Treasury yield by as much as 40 basis points.
This argument, if true, implies risks to long-term interest
rates and to the U.S. economy going forward. If foreign
governments were to decide to "diversify" their
foreign currency reserves (Koizumi 2005) and reduce their
demand for U.S. Treasury securities, the yields on these
and other long-term instruments, such as mortgages, would
move up. This could have a negative impact on the economic
outlook. In this Economic Letter, I examine this argument
and find that it fails to account for a number of significant
issues surrounding long-term rates and foreign official
purchases of long-term U.S. Treasury securities. I then
show that, given the structure of the market for U.S. Treasuries,
a sharp hike in rates would be unlikely even if foreign
governments were to reduce their purchases substantially.
What is wrong with a "simple" analysis
of the conundrum
Long-term interest rates are closely linked to long-run
inflation expectations and long-term real interest rates,
which, in principle, are determined by macroeconomic fundamentals,
such as long-run productivity growth and possibly fiscal
deficits. Therefore, by regressing long-term interest rates
on inflation expectations and macroeconomic fundamentals,
one can assess how far today's long-term yields deviate
from what the fundamentals suggest they would otherwise
be.
 The
results from one such regression are shown in Figure
1. The solid line shows the difference between the actual
10-year Treasury rate and the rate predicted by this
regression,
that is, the prediction error. The significantly negative
error in the most recent period points up the conundrum—the
model predicts long-term interest rates that are noticeably
higher than actual (other models also lead to qualitatively
similar results). The dotted line in the figure plots
net foreign official purchases of U.S. Treasuries (summed
over
12 months) as a percentage of the U.S. GDP. A glance
at just the current episode shows that the significantly
negative
prediction error for the 10-year rate coincides with
a very rapid increase in foreign official purchases of
U.S.
Treasuries since 2002. Indeed, some analysts include
foreign purchases in the regression and find results
implying that
the $235 billion foreign official purchases of U.S. Treasuries
in 2004 lowered the 10-year yield by about 40 basis points.
However, Figure 1 also shows that these two series do
not always move in the opposite direction. Indeed, in most
of 1980s and 1990s, they appeared to move in the same direction.
For instance, when net foreign purchases declined from
about 1% of U.S. GDP in July 1988 to -0.14% in December
1989, the 10-year Treasury yield actually dropped by 120
basis points, about 90 basis points of which was unjustified
by the macro fundamentals. Another striking example happened
during the period from 1993 to 1996, when foreign purchases
surged (from 0.5% to 1.5% of U.S. GDP), but the 10-year
yield did not decline substantially. Indeed, the correlation
between our measures of the 10-year rate prediction errors
and the foreign purchases is 0.3 between 1987 and 2000,
in contrast to the negative correlation since 2002. This
clearly indicates an unstable relationship between them.
Moreover, the observations during the 1980s and 1990s
also indicate an important but often overlooked econometric
problem embedded in running simple long-rate regressions:
causality can go either way. In other words, long-term
yields may respond to foreign purchases, but foreign purchases
also may respond to long-rate movements; for example, when
long-term yields rise and long-term Treasuries become more
attractive, foreign central banks may be more willing to
purchase them. To evaluate the impact of foreign purchases
on long-term yields, then, one needs a more sophisticated
model than the simple (yet popular) single-equation regression
model.
An alternative approach
Rather than running a regression, one can analyze the
structure of the market for U.S. Treasury securities to
help evaluate whether foreign official purchases might
have a significant and persistent influence on it.
The hypothesis that foreign official purchases hold down
yields on long-term U.S. Treasuries relies on two premises:
(1) foreign official purchases (and holdings) of U.S. Treasuries
must be predominantly concentrated in securities with long-term
maturities (10-years and longer), so that a reduction in
foreign official holdings would translate into a similar
reduction in demand for long-term Treasuries; and (2) foreign
official demand must account for a substantial part of
the overall demand for long-term Treasuries. In addition,
both premises assume that the long-term Treasury market
is heavily segmented from the shorter-term Treasury market
and from other financial markets such as the corporate
bond market; only in that case will reduced demand from
foreign central banks cause long-term rates to rise abruptly,
because it creates a vacuum that cannot be easily filled
by other investors in any of those markets.
 As for the first premise, foreign governments' holdings
are not concentrated in long-term Treasuries. As Chairman
Greenspan (2004) pointed out, "…(foreign) central
bank reserves are heavily concentrated in short-term maturities." For
instance, as of December 2004, foreign official institutions
held $1.173 trillion in U.S. Treasury securities, with
$245 billion, or 21%, in the form of Treasury bills whose
maturities are less than one year. Moreover, the Treasury
notes and bonds they bought in the past gradually mature
(for instance, the 10-year Treasury bought nine years ago
will mature next year), so the actual maturity of their
Treasury portfolio is even shorter. As Figure 2 shows,
as of June 2003, over half of foreign central banks' holdings
of Treasuries would mature in two years or less, and only
27% had an actual maturity of five years or longer by then.
In short, foreign central banks' U.S. Treasury portfolios
are quite diversified and are not concentrated in long-term
maturities.
To illustrate what this information about the structure
of foreign central banks' portfolios of U.S. Treasuries
implies, consider what happens when foreign central banks
want to reduce their holdings of U.S. Treasuries by $100
billion while keeping the same maturity structure as
in Figure 2.  They will not choose to reduce their holdings
of long-term U.S. Treasuries by $100 billion, because
doing
so will substantially shorten the average maturity of
their Treasury portfolios. Rather, they will need to
reduce their
holdings of both long-term and short-term Treasuries
proportionally. Thus the reduction in demand for long-term
Treasuries will
be much less than $100 billion.
The second premise also is questionable. It is true that
foreign official purchases have accounted for a substantial
part of the newly issued Treasuries in the past two years.
However, foreign central banks are not the only players
on the field. Foreign individual investors are at least
as active and important as their central banks (Figure
3). Thus, even if the foreign official purchases of long-term
Treasuries decline, the vacuum could well be filled by
foreign individual investors in the first place. Moreover,
even though U.S. investors' relative holdings have been
declining, they are still the biggest holders of U.S. Treasuries
(Figure 4). They would also be likely to step in once foreign
central banks were to retreat.
 Finally, we examine the assumption that the long-term
Treasury market is heavily segmented from the short-term
Treasury market and other financial markets, so that even
when long-term Treasury prices decline and become relatively
more attractive, investors from other markets will not
be able to jump in and push them back up. There are reasons
to question this assumption, too. The U.S. Treasury market
is highly developed and very liquid, and numerous investors
trade both short- and long-term securities every day for
hedging and other purposes. Even if there is some degree
of segmentation that isolates the long-term Treasuries,
how much price discrepancy it can generate is still questionable.
The short-term Treasury market is, in fact, much larger
than the long-term Treasury market, and the corporate bond
and equity markets are larger yet. Therefore foreign official
purchases account for only a small fraction of the overall
credit flow in the U.S., and any substantial misalignments
in the asset prices caused by foreign official purchases
will be quickly corrected by other kinds of investors.
Notice that a 40-basis-point discrepancy in 10-year Treasury
yield implies a 4% bias in the bond price (assuming zero
coupons), and foreign official purchases do not appear
to be large enough to induce such a bias and sustain it.
To sum up, this analysis suggests that there is more to
solving the conundrum of the recent low long-term interest
rates than pointing to the behavior of official foreign
purchases of U.S. Treasury securities. Indeed, there is
little solid evidence suggesting a persistent relationship
between the two. Furthermore, the structure of the Treasury
market does not support the projection of a rapid rate
hike in the event that foreign central banks retreat from
the U.S. Treasury market.
Tao Wu
Economist
References
Greenspan, Alan. 2004. Remarks on current account, before
the Economic Club of New York, New York, March 2, 2004.
Koizumi, Junichiro. 2005. Remarks
before Japanese Parliament, March 10, 2005.
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