Why are US and European government bond yields so low?

Dr. Mete FeridunSenior Economist

CMPA-London

10-year government bond yields

1- Declining term premia2- Reserve accumulation by foreign central banks3- Overestimation of the output gap4- Low inflation expectations5- Low interest rates6- Flight to safety7- Monetary policies8- Prudential regulations

Possible reasons

Declining term premia in US and UK

• Longer term bonds are riskier and require a “term premium” to compensate for this extra risk

• Term premium is driven by the long-term risk outlook and varies over time as interest rate risk and investors’ risk tolerance fluctuate

• US and UK bond yields are low as the term premium has declined: Uncertainty about economic recovery has improved and as inflation expectations has become more stable

Reserve accumulation by foreign central banks

• Over 30% of US government bonds are bought by foreign central banks – they are “price insensitive”

• Chinese central bank has built up huge foreign exchange reserves to offset the large current account surpluses and prevent fast yuan appreciation - it has invested its reserves in US Treasuries

• This has increased demand for US government bonds, resulting in lower yields. Overseas central banks have also been holding UK gilts for diversification

Overestimation of the output gap

• A narrowing output gap means economy has reached its limits, and further growth will lead to inflation as production and labor costs rise

• Higher inflation expectations damage attractiveness of government bonds

• A wide output gap (or its overestimation) keeps inflation expectations low, increasing attractiveness of bonds

Expectations of low inflation

• Inflation erodes the value of coupon and principal so they demand higher yields if inflation expectations are high

• Inflation expectations in EU and USA are very weak

• There is a strong disinflationary trend in Europe - main fear is deflation and stagnation

• Rising US dollar has reduced inflation risks in US

• Low energy prices have kept inflation expectations low everywhere

Low interest rates

• Central banks signal that the timing for their first interest-rate increase will depend on how the economy performs

• Neither the Fed nor the Bank of England is expected to start raising interest rates until the second half of 2015 amid contained inflation

• In the “new normal” state of weak growth and low inflation, interest rates are expected to remain low

• Expectations of low interest rates in EU and USA makes bonds more attractive as they are safer than deposits

• Low interest rates result in lower interest rates on the newly issued bonds

• This protects the values of existing bonds

• Higher interest rates make newly issued bonds more attractive to buy, reducing demand for existing bonds, diluting their value

• So, low interest rates keep existing bonds attractive

Prudential regulations

• Regulatory capital adequacy requirements push financial institutions to invest in less risky assets

• There has been a shift from risky assets into government bonds by banks and other “liability-driven” investors

• Pension and insurance funds match their long-term liabilities by with government bonds for a secure income

• Conspiracy theory: are governments are forcing savings into government bonds to inflate away their debt?

Flight to safety • Gilts and US treasury bond yields reflect investors’ confidence in

solvency of debtor countries amid few safe investment opportunities - investors remain defensive in their investment strategies

• In EU, government bonds are attractive as “safe heavens” as austerity measures signal the commitment of governments to balancing their respective fiscal accounts. Also, debts of weaker member states ones have been guaranteed

• US bonds are particularly attractive due to yield differentials: European and Japanese bonds offer below 2% on 10-year bonds, US bonds, which are safer, offer of over 2%)

Monetary policies

• In the UK, BoE bought gilts as part of QE programme irrespective of their price - this distorted the market and sent prices higher and yields lower

• US is an exception where yields have risen during periods of QE on the promise of recovery

• QE policies in USA, UK, EU and Japan have increased liquidity and liquidity expectations and have kept interest rates low - market do not “price in” a rise in interest rates