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Wednesday, September 14, 2016

A Puzzle: long-term interest rates

mike smitka

I'm hesitant to post this graph: rates are volatile and I know that looking for trends in financial markets is silly. OK, provisos out of the way. But I've faced a puzzle for the past several years in the flatness of the yield curve. Comparing the difference in rates at various maturities, say between 7 year bonds and 10 year bonds, allows us to calculate the implicit return investors expect to have on a 3-year bond in 2023, some 7 years hence. I normalize all those into equivalent one-year bond rates. Here, that means the rate that you need for back-to-back purchases of three 1-year bonds to make the total return of a 7-year bond and three 1-year bonds equal to that of a 10-year bond.

The puzzle is that such returns have been very low. In the example I just gave, the dark brown line in the graph on the right, that's been below 2%. Are investors really rational in a belief that nominal interest rates will still be below 2% in 2023, due to some combination of (very) low inflation and very low growth? And what of a risk premium? – investors also have to believe there is no downside, that the "tail" of the distribution doesn't include bad outcomes for bondholders!

Now there are surely institutional reasons why certain maturities are focal points, for example there may be classes of investors who want bonds maturing in 2023 to match a need for liquidity at that point, and others who want bonds maturing in 2026, arbitrage possibilities be damned. Markets for intermediate maturities may be thin, so that you pay a penalty for trading non-standard paper. Traders also have finite time, and cannot follow everything, even with computers as aids. Senior managers certainly aren't inclined to spend their time thinking through whether they should be "heavy" at a maturity 8.7 years, and then explaining that to the Board. In sum, focal maturities are convenient for many reasons. But to me it's still a puzzle.

Again, it's only been the past two weeks that things have changed, too little to be meaningful in either duration or magnitude – see the graph providing data for the past 2-odd years on the bottom left, which shows many such blips. But likewise note the graph on the bottom right, which tracks the implied 1-year rate 7 years out since 1990. What we are seeing has no precedent over the past quarter century. Why anyone would buy a 10-year bond that yields under 1.75%? Yes, the Fed can push short rates down. Yes, they hold a lot at longer maturities, the result of quantitative easing – in which they no longer engage. Yes, other central banks around the world have been or are engaged in QE while pushing short rates into negative territory. Perhaps with the rich world aging there really is a demand for the "safety" of bonds that is "outstripping" supply to generate low yields? I remain puzzled.

Why anyone would buy a 10-year bond that yields under 1.75%?