Reports that several Federal Reserve board members are contemplating ‘additional stimulus’ (whatever that means) prompts the question as to just how low the US 10yr yield can go? While the Fed can only effectively control the short rate, which is zero, long-term interest rates are mostly market determined. The 10yr yield is currently 1.78% – my bet is that it falls below 1%.
April and May witnessed an incredible turnaround in the US bond markets that sold off so violently in March. Long term yields are now lower than they were before the correction took place – an outcome that almost all traders and investors had completely discounted. The very forces that have driven yields to historic lows remain in place to drive yields lower still. Let me elaborate…
First, the major capital pools in Asia and the Middle East sit with official institutions. These foreign reserves would generally be invested in developed nation sovereign bonds…but, as I have argued before, these countries were abandoned by Europe during the Greek debt restructuring and forced to take a haircut. In retaliation, these countries have stopped buying European debt. This leaves only a small handful of highly rated developed nation sovereign bonds to invest in – the US, Australia, New Zealand and Japan. Of these candidate markets, only the US is large enough to handle these investors’ volumes. Put simply, the US bond market is the destination for recycled trade surpluses.
Second, with the emerging markets offering the most productive workers per dollar cost, these economies are attracting physical capital investments. The marginal product of capital in the US has been driven down due to taxes, regulation and wage protections, to a point where the US is no longer competitive.
Taken together – too much money chasing too few investments – these two facts signal lower long term interest rates. And nothing looks like changing this dynamic for a long, long time.