The Fed is cutting rates while longer-term yields refuse to fall. 

Former Fed Chair Greenspan said that the refusal of longer-dated bond yields to rise in the mid-2000s as the Fed hiked rates was a conundrum. Some blame this conundrum for the financial excesses that led to the 2008/09 global financial crisis. Fast forward twenty years and we seem to have another conundrum.

Many reasons were put forward for the fact that some 425-bps of Fed rate hikes between mid-2004 and mid-2006 were unable to lower 10-year treasury yields which stayed pretty constant in a 4-5% range through much of the tightening cycle. Nobody would have expected long-term yields to rise as much as the fed funds target rate, but some sort of rise was anticipated.

All manner of reasons were put forward for the conundrum with perhaps the most popular being subsequent Fed Chair Bernanke’s explanation that robust demand for treasuries in the face of aggressive Fed tightening was down to a global savings glut, with much of this coming from foreign central banks. Whatever caused it, the consequence seemed to be a ‘reach for yield’ amongst investors who were unhappy with ‘low’ treasury yields but happy to gobble up risky structured products based around the US sub-prime housing market. The rest, as they say, is history as the bottom fell out of the US housing market and the financial world collapsed in its wake.

Now clearly pinning blame on the Fed for all this is unfair but one lesson of the crisis seemed to be that it can be dangerous if the bond market does not do what the central bank wants it to do. The danger back then was that yields did not rise as the Fed anticipated. The danger today is that yields may not be falling as the Fed would like – and certainly not as President Trump would like - given that the government is currently making more than USD1tr in debt interest payments each year.

One obvious place to look for an answer could be the same place that Bernanke looked – overseas investors. For if it is the case that the global savings glut that Bernanke spoke about has morphed into global saving deficiency it would seem to offer a neat explanation for the treasury market’s performance. But we are not sure that this is correct. If we take central banks, for instance, reserves are rising pretty rapidly. Instead, what seems to be happening here is that there is notable diversification away from treasuries and into gold (and other currencies). The Fed’s holding of treasuries in custody for foreign official institutions (mostly central banks) has declined a very substantial USD172bn over the past year. They are down to the lowest level since 2012. In this time global reserves have risen by around USD5tr.

Another explanation is that a global savings glut has been replaced by a global bond glut, led by treasuries as governments have racked up huge debts and central banks have conducted quantitative tightening to lighten their bond load. This seems reasonable but one thing to point out is that there are many central banks around the world that have cut rates in a very similar way to the Fed and yet have seen their bond yields tumble even though their inflation performance has not necessarily been much different. One that comes to mind here is the SAGB market.

Steven Barrow, Head of Standard Bank G10 Strategy, said this might be a US problem, just as the Greenspan conundrum seemed to be in the mid-2000s. It was a US problem back then possibly because the US treasury market was the only one large enough to accommodate all of this savings glut. But if it is a US problem now it seems more likely to be due to the doubts investors have over US policymaking, such as fiscal policy and political pressure on the Fed. So, while it might also be a conundrum, the explanation lies in a different place. “Whether that makes it potentially more disruptive than the original conundrum is hard to say, but we would certainly stay wary of treasuries even though we expect the Fed to cut some more”, said Steven Barrow.