Apprehension expressed by economic and financial pundits about potential runaway inflation and higher interest rates in the wake of the U.S. Treasury’s recent issuance of bonds is high. The concern follows the government’s plan to issue $3 trillion in fresh debt to help fund pandemic-era fiscal stimulus as well as the post-pandemic economy. Our assessment of both the economic and policy paths strongly implies that pundits’ worries will not become actualized in the near term.
Both the fiscal and monetary authorities have ample room to provide support during the current-crisis era and to bolster growth in the post-pandemic economy. Inflation, interest rate shock and a crowding out of investment do not appear to provide outsize risks to the economic outlook.
The yield on 10-year Treasury bonds has been in a secular decline since former Federal Reserve Chairman Paul Volcker demonstrated to the world how to squeeze the life out of inflation in the late 1970s. In the four decades since, central bankers learned to target inflation, while a confluence of events in the real economy have limited consumer price increases to the exception, rather than the rule. Since the bursting of the housing bubble in 2008, inflation has risen above 3% only once. That was in 2012, when we expected inflation to rise as more people were working and able to make non-essential purchases. Since 2008, the core PCE, the Fed’s inflation policy variable, has averaged 1.57%, well below its 2% inflation target.
Inflation targeting by the central banks has resulted in diminished expectations for inflation, shown in the figure below, and the worldwide compression of interest rates. Yields on 10-year Treasury bonds have been dropping since late-2018, when the global cost of the U.S. trade war became apparent. Ten-year yields have dipped to less than 1% since the March 2020 onset of the novel coronavirus pandemic.
As we’ve discussed before, 10-year yields can be broken down into two components: (1) expectations of short-term interest rates over the life of the bond, and (2) compensation for the risk that short-term interest rates might not follow those expectations. The path of short-term interest rates is determined by Federal Reserve guidance and the central bank’s setting of the federal funds rate. Nevertheless, an investor will require compensation for what we call “event risk,” such as the risk of a trade war or a pandemic, which causes a divergence in that path. Faced with the choice of holding a bond until term or buying a series of risk-free, short-term money-market securities, the investor will require compensation in the form of a risk premium—a “term premium.”
As shown by the green line in the figure below, expectations for short-term rates have been in decline since late 2018, when it became apparent that the Fed would have to stop its interest-rate normalization program and cut the federal funds rate once again in response to a slowing domestic and global economy.
If yields along the yield curve have become compressed, why then have 10-year yields continued to fall below the expectations for short-term rates?
The drop in the term premium into negative rates—shown in the red line in the figure below—reflects investors assigning greater probability over time of a recession and the risk of a severe drop in demand, deferred spending by households and therefore an increased risk of deflation and a decrease in the real return on the investment, which is paramount.
If issuance continues to increase, will there be enough demand to keep interest rates low?
The first figure below shows the bid-to-cover ratio of Treasury bond auctions since 2000. The bid-to-cover ratio can be a measure of the demand for bonds, with a ratio of 2.0 indicating twice as many offers to buy the bonds relative to the amount auctioned. As the figure below shows, the ratio has rarely dipped below 2.0 since 2004.
There are supply considerations in addition to the demand side. We could attribute the dips in the bid-to-cover ratio at the outset of the 2001 dot-com bust and the 2008-09 Great Recession—as well as the latest episode—as the result of an increase in issuance at the outset of a recession. But those dips might also be due to the increased need of investors to hold cash in order to meet short-term obligations. Regardless, the Fed is likely to continue mopping up the supply of Treasury issuance via its quantitative easing operations and the expansion of its balance sheet.
The demand for U.S. Treasury securities by foreign investors over time seems undiminished, despite the secular decline in U.S. interest rates, shown in the figure below. Foreign purchases are the result of the safe-haven demand for the guaranteed returns of U.S. securities, the potential for increases in return due to the strength of the dollar, and transactional demand as profits from our trading partners are parked in Treasury securities.
It is unlikely that these conditions will be overturned, though there are uncertainties regarding the spread of the novel coronavirus and the depth of the commitment by the administration and Congress to minimize damage to the economy. Along with the virus’s spread, we must also consider the depth of the economic slowdown in the economies of our trading partners.
Despite the low return, the Treasury market remains the safest game in town. It would take a deflationary spiral to change that reality. Moreover, it is more likely that the Fed will increase its purchases of Treasuries if pandemic-era economics require a more aggressive stance to support growth and bolster employment conditions. What lies beyond that are the economics surrounding yield curve control.