Should We Fear Rising Bond Yields?

There seems to be some concern as to the rising yields on long-term bonds. Our friend Jimmy P. (now of Reuters) quotes Scott Grannis, who writes:

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an to keep their yields low is a self-defeating strategy … Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise.

This presents two interesting questions:

1. Is the Fed trying to lower long-term rates?

2. Are rising long-term rates a bad thing?

I think that the answer to (1) is ‘no’. Counter to what seems to be the conventional wisdom, I believe that the Fed is buying long-term bonds because because short-term bonds and cash having largely been near perfect substitutes for quite some time. Thus replacing an asset that banks are gladly holding at near zero yield for an asset that earns zero yield isn’t likely to create the proper incentive to expand the money supply and stimulate economic activity. Buying the longer term debt, on the other hand, serves the purpose of creating the incentive to replace said debt with something that earns a return, thereby promoting lending and monetary expansion. What’s more this monetary expansion, if successful (or, more appropriately, credible) will begin to create an increase in inflation expectations, reduce the real interest, and therefore create demand for investment.

This latter point brings us to question number 2.

I similarly think that the answer to (2) is ‘no’ as well (or at least ‘not yet’). The creation of inflation expectations will temporarily lower the real interest rate, but as these expectations become more widespread the nominal interest rates will start to creep up. The recent increase in nominal rates is seen by some (including Scott Grannis, above) to be a sign that investors are worried about inflation. I am not convinced that this is the case for two reasons.

First, the nominal rates on bonds have been at historically low levels for some time. These low rates are largely the result of expectations of deflation and, more importantly, the flight to quality. Given this diagnosis, it is not surprising that these longer term bond yields have started to rise. Indeed, Martin Wolf (HT: David Beckworth) notes:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone.

The most important point to take away from this is that inflation expectations are in line with rates in which the Federal Reserve is quite comfortable. Thus, I am not trying to argue that rising inflation expectations have played no role in the rising bond yields, but rather than these increases are the result of a return to normal conditions (hence my reason for offering the qualification ‘not yet’).

The second reason that I remain unconcerned about the rising yields is that the phenomenon is not unique to the United States. One of the main points underlying the inflation expectation concerns is that the Federal Reserve will monetize some of the growing debt (or similarly about the risk of default). However, if increases in bond yields were the result of the growing budget deficit and debt, then one would expect to see such increases in the United States, but not countries with relatively small deficits. With that being said, Stephen Gordon’s recent comparison of the yields on Canadian and U.S. bonds throws a wet blanket on this hypothesis. He notes:

As we all know, Canada’s deficit and debt picture resembles in no way that of the US. But a US recovery is a sufficient (although perhaps not necessary) condition for a Canadian recovery.

If investors were suddenly concerned about default, it’s hard to see why Canadian bond yields should be affected in the same way that US yields would be. But if investors are anticipating a US recovery that would spill over to Canada, then we would expect long-term interest rates in both countries to increase.

Thus, like Gordon, I would argue that the rising yields are a good thing as they seem to indicate a return to normalcy rather than runaway inflation expectations. This is also a sign that the Fed’s policy of quantitative easing is working (at least in terms of what I believe to be the Fed’s goals).