| The Treasury’s announcement that they will no longer issue 30-year bonds was rumored just before the announcement but it was largely a surprise. The bond market has reacted accordingly, recognizing that existing 30-year Treasury bonds will have an increasing level of scarcity value going forward. While the announcement will no doubt put downward pressure on long-term interest rates in the short-run, there’s certainly no guarantee that the Treasury’s actions will produce low long-term interest rates in the long run. There are a few reasons for this. First, supply is largely a technical issue; in the long run fundamentals are the main driving force behind the behavior of bond yields. More important determinants of bond yields include inflation expectations, competition for capital, the performance of the dollar, and the level of economic activity. Supply is simply a background issue. Consider Japan, for example. They have enormous levels of debt yet long-term interest rates are low. Why? Largely because of deflation and weakness in both the Japanese economy and the stock market. With deflation arguably around –2.0%, and long-term interest rates at 1.4% in Japan, Japanese bond investors are more focused on the real interest rate of 3.4% than they are on the deluge of Japanese debt. Similarly, in the U.S., during WWII, the debt-to-GDP ratio rose above 100% yet long-term interest rates stayed low because of positive underlying fundamentals. And in the early 1990s, interest rates plunged despite a large budget deficit, owing to weak economic growth and disinflation. |
