Financial and Monetary Systems

Something in the global economy doesn't make any sense

A businessman passes by the Bank of Japan building in Tokyo March 18, 2009. Japan's central bank said on Wednesday it would increase the purchase of government bonds by almost a third as the government prepares more spending to help the economy in its worst recession since World War Two.

US Treasury bond yields have fallen to an all-time low. Matt O'Brien explains why this shouldn't have happened. Image: REUTERS/Yuriko Nakao

Matt O'Brien
Reporter, Washington Post
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Bond yields aren't always the most exciting thing in the world, but they are right now.

In fact, you'll probably be telling your grandkids about them one day. That's because the yield on the benchmark 10-year U.S. Treasury bond plunged to an all-time low of 1.37 percent on Tuesday. Not only that, but it's done so at a time when unemployment is a relatively normal 4.7 percent. This isn't, to say the least, what's supposed to happen. But it is what's happening, here and everywhere else, because the world economy is turning Japanese. Which, as we'll get to in a minute, means that future generations might have a harder time believing that rates were ever this high rather than this low.

In my day, you had to walk to school uphill both ways, and pay interest to borrow money.

How quaint. It was the way things worked, though, up until a year ago. Long-term interest rates, you see, reflect what markets think short-term interest rates will average over that time, plus a little extra to make up for the fact that it might end up being more than that. So it was hard to see how that could ever be something as low as 1.37 percent, especially when unemployment was low itself. That last part, after all, should make growth go up, and, as a result, make interest rates do the same since there'd be more inflation for central banks to fight.

But "should" is a funny word. Yields are now negative 0.19 percent for 10-year German bonds, negative 0.27 percent for 10-year Japanese bonds, and negative 0.61 percent for 10-year Swiss bonds. And that's despite the fact that Germany only has 4.2 percent unemployment, Japan only has 3.2 percent, and Switzerland only has 3.3 percent. What in the name of positive returns is going on? Well, the same thing as always. It's just that all of them have below-zero interest rates today, all of them are expected to have below-zero interest rates tomorrow (and pretty much every day after that), and all of them have falling prices that will make their currencies worth more in the future too. Add it all up, and it's not completely crazy that investors are willing to pay for the privilege of lending to these countries. People don't think interest rates will go up anytime soon, but they do think the money loan out will go up in value.

So markets are working like they usually do. It's the economy that isn't.

And the United States isn't immune. Now, on the one hand, it has done better than Europe and Japan. The 10-year U.S. Treasury bond yield is at least positive and even above 1 percent. That almost qualifies as an accomplishment nowadays. But, on the other hand, the 10-year U.S. Treasury bond yield is, well, barely positive and not much above 1 percent. That would have been unthinkable before the Great Recession when 10-year yields were 5 or 6 or 7 or even 8 percent. This is the market's way of telling us that its vision of the future is 1.5 percent growth stamping on a human face — forever. That's the only way that lending money at 1.37 percent for 10 years makes any kind of sense.

But hold on. How is it possible that interest rates could stay this low this long without causing a boom that would force the Federal Reserve to hike them? Well, ultra-low interest rates might not be as much of a boon as they used to be. That, at least, is what the Fed thinks. It says the Goldilocks interest rate that neither helps nor hurts the economy has fallen from 4 percent before the crisis to 2 percent today. Of course, it hopes this will only be temporary, but it might not. As Larry Summers points out, this has been going on a lot longer than just since 2008. For 30 years now, it's taken lower and lower interest to produce the same amount of growth — if that. Part of that might be that this has been the only way to get people to make new investments when we don't need as many new houses or offices in our post-boomer economy. And the rest of it might be that even what were lower rates weren't low enough after Lehman scared people out of borrowing. Whatever the case, though, the end result is that the economy doesn't seem like it can grow unless interest rates are zero.

The rest of the world has only made this more true. That's because zero interest rates in one country exert a kind of gravitational pull on interest rates in another. They're "contagious," as economists Gauti Eggertsson, Neil Mehrotra, Sanjay Singh and Larry Summers put it. Here's why: if you have zero interest rates and are expected to for a while, then capital will flow into my economy every time I even consider raising my own. Money, after all, moves to where it thinks it can get the best return. But on a less happy note, this will push my currency up so much that my exports will start to lose competitiveness. And that, in turn, will slow my economy down enough that I won't actually have to raise rates. Instead, I'll keep them around zero — just like yours. The same kind of thing happens any time there's any financial turbulence in the world. Investors stampede into the safe haven that is U.S. government debt, pushing down yields and pushing out expectations of rate hikes.

10 year treasury yields since Fed's rate hike
Image: Wonk Blog

That, as you can see above, is what's going on now. The yield on the 10-year U.S. Treasury bond has fallen 0.3 percentage points since Britain voted to leave the European Union two weeks ago, and almost a full percentage point since the Fed raised rates last December. It's been enough that futures markets went from thinking there was an 85 percent chance at the start of the year that the Fed would increase interest rates again at some point later in it to a 50 percent chance a month ago to just 10 percent today. Markets, in other words, think rates have nowhere to go but nowhere.

The paradox is that the economy can only handle higher rates if the Fed says it won't raise them. Anything else will create so much turmoil that the Fed won't even be able to pretend it's going to increase interest rates as much as it was before. That's why long-term rates actually fell after the Fed raised short-term rates at the end of last year. Add in the angst from overseas — this time born in Britain instead of Greece or China or Greece or China or Portugal or, well, China—and you've got 10-year yields at a level that would normally be bad for 1-year yields. Now, maybe these Brexit fears are overdone, and yields will stop their descent into Japanese territory. Or maybe not. Maybe the rest of the world will drag our long-term interest rates down to zero as well.

There's never been a better time to borrow money. It's too bad we're not doing more of it.

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