In the Weeds

The yield on the 10-year U.S. government bond went below 2.5% this morning! Given that the Federal Reserve Bank is now paring back its monthly purchases of government and mortgage debt (its “quantitative easing” or “QE” … see: CNBC Story), this is so counter-intuitive that I feel compelled to explore why this might be occurring. I realize that such an excursion is, to many, a romp in the weeds, but this development is of such vital importance to the future well-being of our economy, that I must get out the ole Weed Wacker.

First the obvious … the yields on government securities are going down (and prices are going up) because there is an increasing demand for this debt … despite the fact that the Fed is buying less of it.  And also, as indicated in the above referenced article, there is also a reduced supply of new government bond issuances due to our shrinking federal deficit.  But, importantly, this effect is just at the margin, it does not diminish the enormous supply of existing U.S. government debt ($17.5 trillion and still growing). In fact, this YTD reduced new federal debt issuances can just about match the decrease in Fed QE purchases (minus $177 billion vs. an estimated minus $150 billion). Therefore this current lower bond yield anomaly appears to be very much more an increased demand phenomenon.

The question then is why is the demand increasing for U.S. government debt. One reason may be that investors were expecting a punky stock market this year (after a booming stock market in 2013) and therefore swung to bonds. According to the above article, “around $85.52 billion has flowed into bond funds so far this year, outpacing the $45.98 billion that flowed into equities over the same period.” Also both the European Central Bank and the Bank of Japan have gone to school on Ben Bernanke’s monetary strategy … and are now out-easing the United States. The result is bond yields in these countries are falling to new lows … see: Business Week Story. This, of course, makes “safer” U.S debt more attractive on an arbitrage basis … and off-shore money is also now flooding into the U.S. bond market.

However be warned, if anyone buying 10-year U.S. government securities expects to hold them to maturity and then get their money back in full, you might be better off smoking another type of weed.