Three months ago, the yield on 10 year US treasury bonds was 4.9% and market participants were nearly unanimous in expecting it to go considerably higher. They were spectacularly mistaken. The yield fell below 4% in late September.
The world's central banks are creating too much paper money to allow interest rates to rise. In this new age of fiat money, the rules have changed. From now on, the supply of money will be at least as important as the demand for it in determining interest rates.
Once upon a time - before the breakdown of the Bretton Woods System - interest rates were determined by the supply and demand for money. That is still true today.
There is one very important difference, however. Then, there was a limited amount of money and governments did not have the power to create it at will.
Today, governments can create as much money as they want. This convenience makes global economic management very much easier.
Then, if governments spent more than their tax revenues, government borrowing pushed up interest rates and crowded out the private sector. Today, that is no longer true... at least not for the United States government.
Today, the interest rate on the US 10 year Treasury bond is determined primarily by the relationship between the demand for money from the US Federal Government and Government Sponsored Enterprises (like Fannie Mae) and the amount of paper money created by the United States' trading partners, which, in turn, is generally (but not always) determined by the size of their trade surplus with the United States. Capital markets were stunned in recent months by the sharp drop in 10 year treasury bond yields.
The explanation for the unexpected decline is simply that the supply of paper money outstripped the demand for it as government debt expanded less than the US current account deficit. Consider the data in the table below.
The table shows the amount of debt outstanding for 1) the federal government, 2) the government sponsored enterprises, 3) agency & government sponsored enterprises mortgage pools, and 4) the three combined. It also shows the quarter on quarter increase in debt for each of the above. Finally, the table provides the size of the US current account deficit for the last seven quarters.
Strong economic growth resulted is higher than expected tax revenues in the United States during the first half of 2004. Consequently, the increase in US government debt slowed very sharply during the second quarter.
In July, the President's Office of Management and Budget revised down their estimate of the US budget deficit by $76 billion for 2004 to $445 billion from their original estimate of $521 billion made in February due to stronger than expected tax revenue growth.
At the same time, the Government Sponsored Enterprises (GSEs) became considerably less aggressive in expanding their balance sheets. The intensifying scrutiny of the accounting practices of Fannie Mae and Freddie Mac may well have been a factor behind their reduced appetite for debt.
In any case, the combined growth in federal government debt and agency related debt slowed very considerably in the first half of this year. Moreover, given 3% plus US GDP growth in the third quarter and the growing scandal at Fannie Mae, these trends for reduced debt issuance most likely continued into the third quarter.
The trend in the size of the US current account deficit moved in the opposite direction, however.
The central banks of the United States' trading partners printed as much money as was necessary to acquire all the dollars entering their economies to prevent their currencies from appreciating... and with those dollar they bought US treasury bonds and agency debt. However, as can be seen below, beginning in the second quarter of 2004, the increase in the amount of new debt being offered by the government and government sponsored enterprises was insufficient to meet the demand for it.
That's why interest rates fell. More paper money is currently being created as a result of the rapidly expanding US current account deficit than is needed to fund the budget deficit and the GSEs' demand for credit. This surfeit of money also explains why the interest rate spread on corporate bonds over treasuries is at multi-year lows.
Classical economic theory taught that changes in the demand for money determined the level of interest rates since the supply of money was fixed. Today, that is no longer true. Keep an eye on the supply. It's exploding!
Richard Duncan is a financial analyst based in Asia and author of The Dollar Crisis: Causes, Consequences, Cures (John Wiley & Sons, 2003)