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June 22, 2005

It's Once in a Blue Moon...

There is actually something worth reading on the Wall Street Journal editorial page. Mirabile visu:

WSJ.com - The 'Conundrum' Explained: Roger Altman: The obvious challenge is to explain these unprecedented interest rate responses. This brings us to a discussion of the relative merits of the three popular explanations mentioned earlier.

The first is simply that the bond market is wrong. All major financial markets periodically overshoot on both the upside and the downside. Now, it is argued, bond prices, which move inversely to yields, have overshot on the upside. It follows that there will soon be a typical correction which will move longer-term rates back up.

But, there is no empirical evidence of an obvious overshoot.

Another popular explanation is that the consensus economic forecast for 2006 is overly optimistic. The leading forecasters are calling for another year of steady GDP growth in the 3.0% to 3.5% range. Since a third consecutive year of such healthy growth normally will move interest rates upward, they are forecasting that result. Others dissent and envision a weaker economy next year. They see the index of leading indicators in decline, weak manufacturing data and a possible housing slowdown and thus anticipate a growth rate falling into the 2% range, especially during the latter months of 2006. Since financial markets historically discount future economic developments by at least nine months, this would explain why longer-term rates have been declining. Yet, the positive economic signs, as detailed in Mr. Greenspan's latest testimony, are far more prevalent and make this a dubious case.

The third explanation involves the so-called savings glut outside the U.S. While America is running big international deficits, much of the world is incurring surpluses. It is not uncommon for mature economies like Japan, Switzerland and Taiwan to run such surpluses. Their aging populations save at high rates and their slow economies don't offer proportionate investment opportunities.

What is uncommon is for developing regions to run positive international accounts. Historically, they have grown rapidly and consumed foreign capital on a net basis. But today the opposite is true. Remarkably, Latin America, China, Africa and the Middle East are in surplus, as shown in the chart nearby.

By definition, such unprecedented foreign liquidity must be invested, and more of such capital usually flows into fixed income instruments than equities. Believe it or not, comparable rates outside the U.S. are even lower than ours. Economic growth is so anemic in Europe and Japan, for example, that the yield on Japan's 10-year government bond is 1.3%, while the 10-year German Bund is at 3.3%. At the margin, therefore, the highest returns are realized on American bonds. That is why this excess foreign liquidity has nowhere else to go.

This is the one aspect of our overall financial picture which is both new and carries significant impact. On that basis, it is a more likely explanation of the conundrum than either a misguided bond market or an incorrect consensus economic forecast.

The final question is whether this unprecedented phenomenon will continue to suppress U.S. long-term interest rates. The logical answer is yes -- but not indefinitely. At some point, foreign investors' holdings of dollar-based assets will rise beyond any prudent standard of diversification. They will then, at minimum, stop adding to these holdings. If nothing else changes in the interim, that will end our interest-rate honeymoon.

Nevertheless, I'm not satisfied with Roger Altman's explanation. Long-term bonds are long-term assets: they should be pricing into their values today what will happen in five (or less?) years when the U.S. current account shrinks and foreigners begin to worry about their large holdings of dollar-denominated assets.

And Roger does not pay attention to the important fact that a great many of the dollar-denominated securities added to foreign portfolios in the past four years have been added not by private investors but by governments boosting their reserves beyond reason.

Posted by DeLong at June 22, 2005 03:52 PM