IF THERE’S ONE THING that confuses me no end, it’s this: Why are interest rates—specifically long-term Treasury yields—so low?
The yield on the 10-year Treasury note has lately been close to 1.6%, with 30-year Treasurys at around 2%. Yet year-over-year inflation is currently somewhere between 4.4% and 5.4%, depending on your favored metric.
Think about what this means: Inflation-adjusted yields for both 10-year and 30-year Treasurys are deeply negative, assuming inflation remains elevated. Here are five theories for why Treasury yields are so low:
1. Quantitative easing is suppressing yields. Since the onset of the pandemic, the Federal Reserve has been buying $80 billion in Treasury debt each month, along with $40 billion in mortgage-backed securities. Increased demand leads to higher bond prices, which translates to lower bond yields.
This theory may soon be tested. The Fed is expected to begin tapering its quantitative easing as soon as this month and may phase out bond purchases altogether by mid-2022.
2. Yields elsewhere are even lower. Sovereign debt in Europe and Japan sport even lower yields than the U.S. Yields on German and Japanese 10-year bonds both hover near zero. By comparison, 10-year Treasurys at 1.6% or so don’t seem so bad. This is the “best house in a bad neighborhood” argument.
But given the inflationary pressures building globally, this argument seems tenuous. Consumer prices in Germany, for example, recently rose at their fastest pace in 28 years.
3. Investors are counting on the Fed to keep a lid on inflation. It’s hard to change mindsets, especially those forged over the past four decades. As I discussed a few months ago, most everyone on Wall Street, including those working at the Federal Reserve, have only experienced a benign inflationary environment.
A related point: Does the Fed have the will to slay the inflationary dragon should it reappear? More and more, investors have come to assume that the Fed has their back. The last time the Fed tried raising interest rates, it had to reverse course—known as the “Powell pivot”—when the stock market threw a tantrum in late 2018. What will the Fed do if the stock market throws another fit as it tries to raise rates?
4. The Fed is already engaging in yield curve control. Yield curve control is to long-term interest rates what the federal funds rate is to short-term rates. The Fed dictates short-term rates by setting the fed funds rate. In theory, it has little control over long-term rates, which are determined by the market, though influenced by the Fed’s bond-buying program.
Still, the Federal Reserve has been studying yield curve control as another potential policy tool. The notion: Strive to keep longer-term bonds at or below target interest rates. While the Fed hasn’t officially embarked down this path, it’s conceivable that it has been quietly testing it out.
5. Investors believe inflation will be transitory. This is the best-case scenario for Wall Street and Main Street alike. No one benefits from inflation. Well, almost no one. Debtors benefit from inflation because their fixed payments are made in dollars that become less valuable over time.
As pointed out by fellow HumbleDollar writer Mike Zaccardi, we are nowhere near the stagflation of the 1970s and early 1980s. Perhaps this inflation scare will be a case of the barking dog that never bites. Given the immense complexity of the economy, I have no strong convictions either way. If you believe in the collective wisdom of markets, this is the theory that makes most sense.