Interest Rate Weekly: Supply, Demand and Real Rates

Recent years have witnessed a change in debate on three fundamentals for the fixed income markets. Each of these may represent a change from the past or simply a repeat of old errors. We shall see going forward.

A Contrarian View—Supply of Federal Debt: Too Little?

How else could you explain a persistently low Treasury yield curve relative to expectations? Could it be that for the past two years and for the next few years there is a shortage of U.S. Treasury debt? When we view the U.S. Treasury position from a domestic viewpoint, we see large fiscal deficits, but those deficits have declined sharply as spending has slowed and revenues have risen. Long term, the problem of rising entitlement program costs should have led investors to discount the future burden and associated Treasury deficit issues. Yet, no such discounting is apparent. 

From a global view—and remember that capital markets are truly global— perhaps there is a shortage of U.S. federal debt (top graph). For foreign central banks, the need for Treasury debt and the U.S. currency has been greater, given the importance of currency stability and the expansion of trade over time. There is a rising need for Tier 1 capital and flight to safety given the uncertainties of sovereign debt in Europe and the political situation in the Ukraine for private banks, and other financial institutions. 

Demand: Refinancing Risk for Businesses, Repeat 2004-2006?

Meanwhile, the demand for private financing appears robust in the high-grade, high-yield (middle graph) and loan syndication markets. Yet, given  the interdependence of capital markets, spreads on these types of issuances have actually fallen as investors are searching for yield. The question is whether investors are being adequately compensated for risk in the next recession—which will occur eventually. Moreover, have issuers taken on positions that would be untenable if such debt must be refinanced in a period of rising interest rates—an issue reminiscent of 2004-2006? A small change in interest rates can be a problem when leverage becomes excessive—again a reminder of 2004-2006.

Real Interest Rates: Debate on the Neutral Funds Rate 

What is the long-run benchmark rate for the Federal Reserve? Some analysts argue that, historically, the neutral fed funds target rate is at 4-4.5 percent, but recent market performance suggests a lower rate. In 2013, the hint of Fed tapering led to a sell-off in emerging market financial assets and currencies (bottom graph). At the same time, housing starts and home sales reacted quickly to the hint of less monetary accommodation. The net outcome is that the global allocation of capital and the new regime of regulation on housing finance have produced a market more sensitive to anticipated changes in the real federal funds rate. Once again, the context of the global economy and the challenges of slower growth to the funding of entitlements in Europe indicate that the global growth allocation of capital, and thereby real economic growth, is consistent with a funds rate below its historical norm.