The Puzzle Of Low U.S. Treasury Yields via OFR
Long-term bond yields in advanced economies are at historically low levels. In Europe and Japan, this reflects persistent economic weakness and ongoing monetary stimulus. In the United States, the low level of yields is more surprising. Long-term Treasury yields have declined substantially since early 2014, despite a strengthening U.S. economy, the conclusion of Federal Reserve purchases of Treasuries, and broad-based expectations for the Federal Reserve to begin raising interest rates this year. Several explanatory factors appear to be at work: the increasing relative value of Treasuries amid expanded monetary easing abroad; reduced inflation expectations; a decline in the expected steady-state target rate of the Federal Reserve; and new U.S. bank demand for Treasuries. While financial stability risks currently appear moderate, a persistence of low long-term Treasury yields could lead to a buildup of such risks if it encourages excessive borrowing or investor risk-taking.
Developments during the last month
- The U.S. dollar rally paused and U.S. interest rates declined modestly amid weaker U.S. economic data
- U.S. equity indexes made further gains, setting new price records
- Oil prices traded at the high end of their year-to-date range, still roughly 40 percent below 2014 highs
- Uncertainty over Greek government financing began to impact other euro area markets
- Chinese authorities made several important policy moves, including their largest rate cut since 2008 and measures to temper the rapid rise of equity prices
Feature: A Closer Look at Trends in Cross-Asset Volatility (p. 6)
U.S. Treasury yields remain in a historically low range.
Market attention remains focused on the very low level of long-term U.S. Treasury yields. Since January 2014, 10-year yields have declined by more than 100 basis points (Figure 1). That sizable decline surprised market contacts, as it occurred in spite of developments widely expected to push yields higher: the wind-down of Federal Reserve purchases of U.S. Treasuries, a strengthening of the U.S. economy, and broad-based market expectations that the Federal Reserve will begin raising interest rates this year.
Market participants point to several key factors to explain the unexpected fall in yields:
- Increased relative value of Treasuries.Government bond yields in Europe have fallen to much lower levels than in the United States (Figure 2), pushed by weaker economic growth, negative monetary policy rates, and the expanded bond purchase program of the European Central Bank (ECB). These developments have reportedly drawn investment out of European government bonds into U.S. Treasuries.
- Reduced market expectations for U.S.inflation and inflation risk. Disinflation and the sharp reduction in oil prices have reduced market-implied inflation expectations and the premium that compensates for the risk of higher-than-expected inflation (Figure 3).
- A decline in the expected long-run Federal Reserve target rate. Long-term Treasury yields also reflect the expected path of short-term interest rates, which are strongly influenced by the Federal Reserve’s target rate. From January 2014 to March 2015, primary dealers surveyed by the Federal Reserve lowered their median forecast of the long-run target rate by 50 basis points to 3.5 percent.
- Regulatory requirements have increased demand for U.S. Treasuries. U.S. banks have sharply increased their holdings of Treasury securities since late-2013, when the U.S. liquidity coverage ratio (LCR) rule was proposed. The LCR incentivizes large banks to increase their holdings of “high-quality liquid assets,” including U.S. Treasuries. Since January 2014, commercial banks have increased their holdings of U.S. Treasuries by $185 billion (45 percent).
A medium-term persistence of low U.S. Treasury yields could lead to financial stability risks. Persistently low yields can encourage excessive investor risk-taking and excessive leverage. There has already been material evidence of excessive risk-taking during the extended post-crisis period of low interest rates and low volatility (see 2014 OFR Annual Report). Some of the factors noted above may continue for some time, particularly the divergence in economic and monetary policy that has increased the relative value of U.S. Treasuries. If so, an even longer period of low yields could increase the associated risks. Further, diminished market liquidity, mispricing in risk assets, and possible contagion could increase the risk of a disorderly adjustment in financial markets when long-term interest rates do rise.
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