Markets have been in upheaval. The Federal Reserve is taking steps to cool off the economy, as questions loom about the course of the recovery. And headlines are proclaiming that government bond yields are near two-year highs.
But the striking thing about bonds isn’t that yields — which influence interest rates throughout the economy — have risen. It’s that they remain so low.
In the past year, with consumer prices rising at a pace unseen since the early 1980s, a conventional presumption was that the demand for bonds would slump unless their yields were high enough to substantially offset inflation’s bite on investors’ portfolios.
Bond purchases remained near record levels anyway, which pushed yields lower. The yield on the 10-year Treasury note — the key security in the $22 trillion market for U.S. government bonds — is about 1.8 percent. That’s roughly where it was on the eve of the pandemic, or when Donald J. Trump was elected president, or even a decade ago, when inflation was running at a mere 1.7 percent annual rate — compared with the 7 percent year-over-year increase in the Consumer Price Index recorded in December.
If you had run that data past market experts last spring, “I think you would have been hard-pressed to find anybody on the Street who’d believe you,” said Scott Pavlak, a fixed-income portfolio manager at MetLife Investment Management.
Because the 10-year Treasury yield is a benchmark for many other interest rates, the rates on mortgages and corporate debt have been near historical lows as well. And despite a binge of deficit spending by the U.S. government — which standard theories say should make a nation’s borrowing more expensive — continuing demand for government debt securities has meant that investors are, in inflation-adjusted terms, paying to hold Treasury bonds rather than getting a positive return.
The major reasons for this odd phenomenon include long-term expectations about inflation, a large (and unequally distributed) surge in wealth worldwide and the growing ranks of retiring baby boomers who want to protect their nest eggs against the volatility of stocks.
And that has potentially huge consequences for public finances.
“If governments ever wanted to engage in an aggressive program of spending, now is the time,” said Padhraic Garvey, a head of research at ING, a global bank. “This is a perfect time to issue bonds as long as possible and proceed with long-term investment plans — and as long as the rate of return on those plans is in excess of the funding costs, they pay for themselves.”
Weighing the Fed’s Role
Because the government debt issued by the United States is valued, with few exceptions, as the safest financial asset in the global market — and because this debt is used as the collateral for trillions of dollars of systemically important transactions — the monthly and weekly fluctuations of key U.S. Treasuries, like the 10-year note, are watched closely.
There are rancorous debates about the added role that the emergency bond-buying program conducted by the Fed since March 2020 — which included hundreds of billions of dollars in U.S. debt securities — has played in keeping rates down.
Some of the central bank’s critics concede that the Fed’s aggressive measures (which officials are dialing back) may have proved necessary at the start of the pandemic to stabilize markets. But they insist its program, another form of economic stimulus, continued far too long, egging on inflation by increasing demand and keeping rates low — an equation that hurt savers who could benefit from higher returns to hedge against the price increases.
Still, most mainstream analysts also tend to identify a broader gumbo of coalescing factors beyond monetary policy.
Several major market participants attribute these stubbornly low yields in spite of a high-growth, high-inflation economy to a widening sense among investors that a time of slower growth and milder price increases may eventually reassert itself.
“While inflation has surged, they do not expect it to be persistent,” said Brett Ryan, the senior U.S. economist at Deutsche Bank. “In other words, over the long run, the post-pandemic world is likely to look very similar to the prepandemic state of the economy.”
Long-run inflation expectations are still relatively anchored at an annual rate of about 2.4 percent over the next 10 years. This indicates that markets think the Fed will prevent inflation from spiraling upward, despite the huge increase in debt and the supply of dollars.
Lots of Cash in Search of Havens
One potent element driving down rates is that from 2000 to 2020 — a stretch that included a burst dot-com bubble, a breakdown of the world’s banking system and a pandemic that upended business activity — global wealth in terms of net worth more than tripled to $510 trillion. The resulting savings glut has deeply affected the market, particularly for government bonds.
The vast majority of wealth has accumulated to borderless corporations and a multinational elite desperate to park that capital somewhere that is safe and allows its money to earn some level of interest, rather than lose value even more quickly as cash. They view lending the money to a national government in its own currency as a prudent investment because, at worst, the debt can be repaid by creating more of that currency.
The downside for these investors is that only so many stable, powerful countries have this privilege: This mix of exorbitant levels of wealth and a scarcity of safe havens for it has whetted, at least for now, a deepening appetite for reliable government debt securities — especially U.S. Treasuries.
“To have truly risk-free returns and storage of your dollars, where else are you going to put them?” asked Daniel Alpert, a managing partner of the investment bank Westwood Capital.
As the principle of supply and demand would suggest, the combination of high demand and low supply has helped keep Treasury bond prices high, which in turn produces lower yields.
Demographic changes are affecting bond trends, too. As they approach or reach retirement, hundreds of millions of people across developed economies are looking for safer places than the stock market for their assets.
Even in an inflationary environment, “there’s just this huge demand for yield in fixed income from people,” said Ben Carlson, the director of institutional asset management at Ritholtz Wealth Management. “You have all these boomer retirees who have money in the stock market and they’re doing great, but they know soon they’re not going to have a paycheck anymore and they need some portion of their portfolio to provide yield and stability.”
Running Room for Federal Spending
The U.S. Treasury market has grown to roughly $23 trillion, from $3 trillion two decades ago — directly in step with the national debt, which has grown to over 120 percent of gross domestic product, from 55 percent.
But borrowing costs for the American government have trended lower, not higher. Congress issued roughly $5 trillion in Treasury debt securities to finance pandemic fiscal relief, “and we had, effectively, zero cost of capital for most of it,” said Yesha Yadav, a law professor at Vanderbilt University whose scholarship covers the Treasury market’s structure and regulations.
The cost of the interest payments that the U.S. government owes on its debt peaked in 1991 at 3.2 percent of gross domestic product, when the national debt was only 44 percent of G.D.P. By that measure, interest costs now are about half what they were back then.
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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
“If the world’s demand to hold Treasury securities is strong enough, then running budget deficits can be sustainable,” said David Beckworth, a former international economist at the Treasury who is now a senior research fellow at George Mason University’s Mercatus Center, a libertarian-oriented think tank.
The real cost of servicing the debt “has been very low,” said Jared Bernstein, a leading economic adviser to President Biden. Treasury Secretary Janet L. Yellen has made similar assertions about the nation’s debt burden in recent months. And this “real cost” framing was used as a rhetorical salve of sorts when Democrats, joined by 19 Republicans, enacted a $1 trillion infrastructure bill that is expected to increase deficits by more than $250 billion.
Mr. Bernstein stipulated that while debt financing has its place, the White House also believes it has firm limits within its agenda. “The outcome of all this is going to be some mix of progressively raised revenues and investments in essential public goods with a high return financed by some borrowing.”
Looking Ahead, and to the Past
What would have to happen for these rock-bottom borrowing costs to rise significantly? There could be a crisis of confidence in Fed policy, a geopolitical crisis or steep increases in the Fed’s key interest rates in an attempt to kill off inflation. In a more easily imagined situation, some believe that if inflation remains near its current levels into the second half of the year, bond buyers may lose patience and reduce purchases until yields are more in tune with rising prices.
The resulting higher interest payments on debt would force budget cuts, said Marc Goldwein, the senior policy director at the Committee for a Responsible Federal Budget. Mr. Goldwein’s organization, which pushes for balanced budgets, estimated that even under this past year’s low rates, the federal government would spend over $300 billion on interest payments — more than its individual outlays on food stamps, housing, disability insurance, science, education or technology.
Last month, Brian Riedl, a senior fellow at the right-leaning Manhattan Institute, published a paper titled “How Higher Interest Rates Could Push Washington Toward a Federal Debt Crisis.” It concludes that “debt is already projected to grow to unsustainable levels even before any new proposals are enacted.”
The offsetting global and demographic trends that have been pushing rates down, Mr. Reidl writes, are an “accidental, and possibly temporary, subsidy to heavy-borrowing federal lawmakers.” Assuming that those trends will endure, he said, would be like becoming a self-satisfied football team that “managed to improve its overall win-loss record over several seasons — despite a rapidly worsening defense — because its offense kept improving enough to barely outscore its opponents.”
But at least one historical trend suggests that rates will remain tame: an overall decline in real interest rates worldwide dating back six centuries.
A paper published in 2020 by the Bank of England and written by Paul Schmelzing, a postdoctoral research associate at the Yale School of Management, found that as political and financial systems have globalized, innovated and matured, defaults among the safest borrowers — strong governments — have continuously declined. According to his paper, one ramification may be that “irrespective of particular monetary and fiscal responses, real rates could soon enter permanently negative territory,” yielding less than the rate of inflation.
An old rule, still holding true across markets, is that high risk bets reward investors with higher yields, yet bring high loan costs for borrowers. Low-risk investments, in turn, come with cheap borrowing costs. If the Fed and other central banks continually prove that they can stabilize (or bail out) the most systemically important governments, then investment risks are flattened — and there could be plenty of leeway to borrow for years to come.