Warning—Falling (U.S. Treasury) Objects

IMF Blog, February 12, 2015

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Bibliographic details

• Authors: Nigel Chalk, Jarkko Turunen
• Published: February 12, 2015

Key observations

• Dramatic drop in long-term U.S. Treasury bond yields recent months; 10-year Treasury bond yields at levels not seen since early May 2013.
• Fall in yields has occurred despite general strength in the U.S. economy and positive recent data, and amid broad consensus that the Federal Reserve will soon start raising interest rates.
• Once changes in the expected path of future short-term rates are removed, the term premium has been responsible for a large share of the fall in Treasury rates; the term premium has turned negative since the start of the year.

Candidate explanations for the fall in long-term yields

• The disinflation vortex:
  • Concern that long-run inflation in the United States could become permanently stuck below the Fed’s goal of 2 percent, reducing compensation needed for future inflation.
  • Market pricing of inflation breakevens has been falling; however, survey data show inflation expectations have not moved much.
• Increasing global risk aversion ("Fear over greed"):
  • Events in Ukraine, Greece, and the Middle East may have driven investors to safe assets, notably U.S. Treasuries.
  • This is likely part of the story, but current low Treasury yields seem incongruent with market pricing of volatility.
• A scarcity of safe assets:
  • Improving fiscal positions in some large industrial countries have reduced net supply of global safe assets.
  • Largest central banks (United States, Japan, United Kingdom, euro area) have bought or plan to buy significant shares of outstanding sovereign bonds, diminishing stock of safe assets for private investors and pushing up bond prices (lowering yields).
• Relative attractiveness of U.S. yields:
  • Although falling, U.S. Treasury yields remain higher compared with many peers; German and Japanese 10-year yields are only 0.3 percent.
• The strong dollar and expected appreciation:
  • Strong U.S. growth performance implies expectations of continued dollar strength; yield differentials combined with expected appreciation should attract flows into U.S. dollar assets and put downward pressure on the U.S. yield curve.
• Likely combination:
  • The authors view the observed fall as likely reflecting a combination of the above factors rather than a single cause.

Implications for monetary policy ("Risk yes, conundrum no")

• The so-called "Yellen conundrum" — that falling long-term rates could thwart the Fed’s ability to control financial conditions — is rejected by the authors.
• Low long-term rates may give the Fed more degrees of freedom:
  • The Fed can steadily raise policy rates; even if long-term rates remain lower than expected, monetary tightening will still operate through exchange rates, interest rates on credit cards and floating-rate loans, and equity prices.
  • Persistently lower long-term rates would support the housing sector, aiding the U.S. recovery.
• If inflation pressures increase (assessed by the authors as unlikely), the yield curve should steepen automatically; alternatively, the Fed could raise policy rates faster to return to neutral more quickly, which could mitigate financial stability risks from ultra-low policy rates.

Risks and scenarios to monitor

• Rapid unwinding of the falling term premium:
  • Historical precedent: in 2013, as the Fed shifted toward tapering bond purchases, long-term rates rose 100 basis points in weeks, triggering a sudden stop in mortgage activity, stalling residential investment, and negative spillovers to the global economy, particularly emerging markets.
• Potential triggers for a sharp increase in yields:
  • Improved economic data (example: a strong Bureau of Labor Statistics jobs report led yields to move off recent lows).
  • Communication missteps by the Fed that surprise markets.
• Possible transitory overshoot:
  • Low Treasury rates could be temporary and may have transitorily overshot fundamentals; hindsight may later view this period as such an overshoot.

Policy recommendations and vigilance

• Continued effective communication by the Fed is needed to avoid surprising markets and to limit the risk of abrupt yield repricing.
• Monitor indicators that could precipitate a rapid snapback in yields, especially:
  • Term premium measures,
  • Inflation expectations and breakevens,
  • Incoming macro data surprises,
  • Market volatility and safe-asset demand shifts.
• Be prepared for policy adjustments:
  • If long-term yields remain unusually low, the Fed could accelerate policy rate increases to return to neutral and to mitigate financial-stability risks.
  • Balance the benefits of low long-term rates supporting housing against the risks of a sharp reversal that could disrupt credit and investment.

Source: IMF blog post "Warning—Falling (U.S. Treasury) Objects", Nigel Chalk and Jarkko Turunen, February 12, 2015.

References

• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-warningsign.jpg
• collapse in the price of oil
• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-chart-1.jpg
• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-chart-2.jpg
• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-chart-3.jpg
• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-chart-4.jpg
• https://www.imf.org/wp-content/uploads/2015/02/whd-us-falling-yields-chart-5.jpg
• U.S. growth performance