Heard on the Street
Fed’s Looming Problem: Too Little Debt
A dearth of Treasurys will limit the Federal Reserve’s ability to affect long-term interest rates.
By Justin Lahart
July 1, 2015 12:57 p.m. ET
The Federal Reserve faces a troubling dynamic as it looks to bring an era of near-zero interest rates to an end. Photo: gary cameron/Reuters With an election year approaching, politicians will be ramping up the rhetoric about America’s looming debt problem. The Federal Reserve, on the other hand, may soon have a different worry: that there is too little government debt to go around for long-term rates to rise meaningfully.
For investors, that portends a friendly market environment, but also raises the risk of assets overheating. Recall how persistently low long-term yields in the mid-2000s despite Fed tightening—a situation then-Fed Chairman Alan Greenspan labeled a “conundrum”—helped fuel the housing bubble. And Greece’s economic crisis may only drive more global investors into U.S. Treasurys, exacerbating the situation.
There are some similarities between today and what was happening during the conundrum. Back then, demand for safe assets from the developing world was sopping up much of the developed world’s sovereign debt. Today, massive quantitative easing programs put in place by the Bank of Japan and European Central Bank are achieving the same thing.
Consider: At current exchange rates, the Bank of Japan and the ECB are buying a combined $120 billion in assets—mostly government bonds—a month. Those debt purchases may increase if the ECB needs to step up its quantitative-easing program to ensure Greece’s crisis remains contained.
The central banks aren’t buying Treasurys, but given that global investors view Treasurys as a near substitute for European and Japanese government bonds, there are spillovers.
Particularly in an environment in which the supply of new government debt is low. Net issuance of long-term Treasurys over the past year—that is, debt issued less debt maturing or otherwise coming off the market—has averaged about $50 billion a month over the past year. Nor does it look likely to head higher.
That is because even though rising health-care, interest and Social Security expenses are a looming problem, they won’t start to really hit until five years out. Meanwhile, due to higher tax receipts and slower government spending, the Congressional Budget Office’s projection for a fiscal 2015 budget deficit of $486 billion is looking far too high. At the current pace, a bit less than $425 billion looks more likely.
In Japan, the euro area and the U.K., net debt issuance is even lower. Indeed, as Bank of England Deputy Governor Minouche Shafik recently pointed out, Bank of Japan and ECB bond purchases exceed net long-term government debt issuance in Japan, the euro area, the U.K. and the U.S. combined.
That creates a potentially troubling dynamic for the Fed as it looks to bring an era of near-zero interest rates to an end. The central bank is on course to start raising short-term rates later this year. The expectation would be that long-term Treasury yields would move higher, too. But they may make only halting gains.
In one sense, that could be good for companies and home buyers, since corporate debt and mortgage rates, among others, are linked in many cases to 10-year Treasury yields. And it could be good for investors, since government debt with low yields offers little competition with other assets, allowing for higher valuations.
The flip side is that the yield curve—the difference between short and long-term rates—would flatten. That wouldn’t make for a friendly lending environment since banks depend on a steeper curve to make money on loans.
Worse still, this situation could fuel speculation, as the flat yield curve did during the housing bubble.
The Fed could try to engineer an increase in long-term yields. One option: stop reinvesting payments of principal it receives on bonds it accumulated in its quantitative-easing rounds. The Treasury would have to boost its debt offerings to cover the Fed’s resulting redemptions. But Wrightson ICAP chief economist Lou Crandall reckons the Treasury would initially issue bills rather than longer-term debt. That could dampen any effect on long-term yields.
So the Fed may have to figure out some other way to crack its new conundrum. Until it does, the biggest threat that investors may face is their own enthusiasm.
In Japan, the euro area and the U.K., net debt issuance is even lower. Indeed, as Bank of England Deputy Governor Minouche Shafik recently pointed out, Bank of Japan and ECB bond purchases exceed net long-term government debt issuance in Japan, the euro area, the U.K. and the U.S. combined.
That creates a potentially troubling dynamic for the Fed as it looks to bring an era of near-zero interest rates to an end. The central bank is on course to start raising short-term rates later this year. The expectation would be that long-term Treasury yields would move higher, too. But they may make only halting gains.
In one sense, that could be good for companies and home buyers, since corporate debt and mortgage rates, among others, are linked in many cases to 10-year Treasury yields. And it could be good for investors, since government debt with low yields offers little competition with other assets, allowing for higher valuations.
The flip side is that the yield curve—the difference between short and long-term rates—would flatten. That wouldn’t make for a friendly lending environment since banks depend on a steeper curve to make money on loans.
Worse still, this situation could fuel speculation, as the flat yield curve did during the housing bubble.
The Fed could try to engineer an increase in long-term yields. One option: stop reinvesting payments of principal it receives on bonds it accumulated in its quantitative-easing rounds. The Treasury would have to boost its debt offerings to cover the Fed’s resulting redemptions. But Wrightson ICAP chief economist Lou Crandall reckons the Treasury would initially issue bills rather than longer-term debt. That could dampen any effect on long-term yields.
So the Fed may have to figure out some other way to crack its new conundrum. Until it does, the biggest threat that investors may face is their own enthusiasm.
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