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10 02 2015 | by Victor Xing | Central Banks

What were the factors behind “Greenspan’s conundrum?”

The pre-2008 flattening of the Treasury yield curve (*) and Alan Greenspan’s bond conundrum can be explained in two parts: the steady rise of front-end Treasury yields as a function of FED policy tightening between June 2004 and June 2006, and several global market factors that kept long-end Treasury yields from rising during the same period (more detail below).

* A brief note for readers who may be unfamiliar with fixed income terms: flattening of the curve refers to the narrowing spreads between front-end (short maturity) Treasury notes and long-end (longer maturity) Treasury bonds.  Yield curves generally have a positive slope, meaning short maturity yields are lower than longer maturity yields, and an inverted curve means long-end yields below front-end yields.

The mid-2004 tightening cycle and “Greenspan’s Conundrum”

Then Federal Reserve Chair Alan Greenspan initiated a series of consecutive rate hikes starting June 30th 2004 to cool the overheating real estate sector.  This significantly pushed up short-term yields in the 2 to 5 year sector, as they are generally more sensitive to expectations of near-term FED policy.

Yet, pushing short-term rates higher only had limited impact on mortgage rates (thuslimited impact on borrowing cost), because 30 year fixed rates are more correlated with 10 year part of the Treasury curve, and yields in that sector remained steady despite FED’s tightening effort.  This is Alan Greenspan’s bond conundrum – why did the long-term rates remain steady despite consecutive rate hikes?

As 10, 20 and 30 year part of the yield curve remained range-bound while front-end rates steadily rose, the yield curve became VERY FLAT with some curve spreads fell below 0 (inverted).  Examples below:

3s20s curve spread

US 3s20s yield curve
US 3s20s yield curve

5s10s curve spread (notice the inverted curve during 2006)

U.S. 5s10s yield curve
U.S. 5s10s yield curve
Greenspan's conundrum
Greenspan’s conundrum

Factors that kept long-term Treasury yields well-anchored

Across the pacific ocean, the Bank of Japan (BOJ) launched its quantitative easing program on March 19th 2001.  It was not known at the time, but long-term global sovereign bonds are highly correlated.  A decline in Japan 30 year yield also pulls down U.S. 30 year yield, as investors faced with financial repression reallocate funds to another country, pushing down that country’s long term yields as a result.

Additionally, The Economist argued in its article “A glut-wrenching experience” that a “global saving glut” also contributed to lower long-term rates.

Then-Governor Ben Bernanke’s  March 2005 speech – “The Global Saving Glut and the U.S. Current Account Deficit” outlined the following:

Countries in the region that had escaped the worst effects of the crisis but remained concerned about future crises, notably China, also built up reserves. These “war chests” of foreign reserves have been used as a buffer against potential capital outflows. Additionally, reserves were accumulated in the context of foreign exchange interventions intended to promote export-led growth by preventing exchange-rate appreciation. Countries typically pursue export-led growth because domestic demand is thought to be insufficient to employ fully domestic resources. Following the 1997-98 financial crisis, many of the East Asian countries seeking to stimulate their exports had high domestic rates of saving and, relative to historical norms, depressed levels of domestic capital investment–also consistent, of course, with strengthened current accounts.

In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets. Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets.

Putting the two together – the Federal Reserve’s conundrum

As the Greenspan FED kept its foot on the brakes in trying to slow down the economy by raising short-term interest rates, global investors (displaced by the BOJ) and foreign central banks were buying intermediate-term and long-term U.S. Treasuries (they didn’t buy short-term Treasuries, because the FED was on a rate hike warpath, and even foreign central banks didn’t want to fight the FED).

The FED succeeded in driving up inter-bank borrowing costs, but the channel which supplied the broader economy with cheap loans was wide open.  That setup the environment for the 2008 financial crisis.

The conundrum had a profound impact on the FED.  QE effectively was a tool that works in reverse.  If the FED can no longer lower short-term rates, and the long-term rates remain high, then the FED will DIRECTLY intervene in the long-term bond market to push down interest rates.

Next article09 30 2015 | by Victor Xing | Capital Markets

Did the ultra-stimulative monetary policy contribute to the energy crash?