Expectations of economists and pundits notwithstanding, interest rates are falling around the world. Despite the end of quantitative easing in the U.S., and the possibility that the Federal Reserve will raise rates later this year, the long-feared economy-killing yield spike has yet to appear.
During the past few months, I have been discussing this with participants in the bond markets and getting a variety of responses. The one I come back to is surprisingly simple: Increased demand for quality long-term bonds combined with a limited supply has created ashortage of investment-grade securities.
As soon as you wrap your head around this, the first thing you encounter is the massive amount of debt the world over. Most of it is pretty low quality. If you are talking about high-quality debt, it isn’t going to be Greek or Russian or Argentinian debt; it isn’t even going to be Italian or French debt. It will be bonds issued by the U.S., Germany or Japan. That’s pretty much it for the high quality, sovereign bonds offered in any real size.
We can certainly find high-quality paper from Switzerland or Singapore or Sweden or even Taiwan (Norway is rated AAA, but it runs a surplus). Throw in Canada, Finland, Australia and the Netherlands and you have pretty much covered the universe of other A-rated countries, though none of them issues a whole lot of debt. Hence, although there may be no shortage of quality issuers, there seems to be a shortage of quality sovereign securities. I understand that might be hard to imagine given all of the debt worldwide, but the key word is quality. There’s lots and lots of bad paper, but surprisingly limited quantities of good paper.
Before you collectively start ranting about QE, we already know that the Fed has been a buyer of U.S. debt for more than five years. Not too long ago, the Bank of Japan joined in with its version of QE. Now, the European Central Bank is in the game as well. But central-bank buying doesn’t account for the shortage of debt that explains the negative yields we see in parts of Europe.
My back-of-the-envelope calculation (that’s the technical term for a fair guess) is that demand exceeds supply by as much as $1 trillion to $2 trillion a year. That is what has been forcing bond prices higher, and driving negative yields.
There are other forces that account for the dearth of debt. The three biggest are:
Market rally rebalancing: Many traditional portfolios made up of 60 percent stocks and 40 percent bonds — often managed by large pension funds, institutions and other asset allocators — follow a simple approach to rebalancing. As equities rise in price, these investors sell some stock and buy bonds to re-establish the original asset weightings. The 200-plus percent rally in the Standard & Poor’s 500 Index since March 2009 is thus a large driver of bond purchases.
Demographics: Those born in the decade after World War II now are between the ages of 60 and 70. The portfolios of retired baby boomers or those who are approaching retirement reflect a more conservative investment posture. As a group, they have been holding more Treasuries and less stock. This very large cohort is yet another source of demand for fixed-income securities.
Lack of new issuance: On the supply side, we are not seeing the usual pattern that follows U.S. recessions. Typically during an economic slowdown there is a surge of stimulus spending, financed by issuing debt. We saw that in 1990-91 and 2001. The pattern was broken this go around. The Great Recession was especially hard on regional economies, forcing state and local governments to absorb enormous spending cuts and reduce their headcounts. Congressional incompetence and intransigence thwarted much of the usual post-recession federal spending and debt issuance.
Thus, the usual big stimulus projects were mostly absent in this cycle. Add to that the winding down of the wars in Iraq and Afghanistan and the reduction in military spending. President Barack Obama, stymied by Congress, was never able to match the government spending increases of his predecessors to help the economy recover from recession.
Had this economic cycle been similar to 2001, unemployment might already be lower than 5 percent and gross domestic product growth could be a half-percentage point higher — and there would be a lot more U.S. debt issued.
Given how low rates are, and the abysmal state of infrastructure in the U.S., now would be a good time for the nation to increase its borrowing — including issuing 50 year bonds to lock in low rates and pay for the big projects the country needs.
Odd as it might sound, if we want to see rates at normal historical levels, the U.S. should be issuing more — not less — debt.