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| Author: | Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance |
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July 1, 2005
Market Eye on Nikkei Financial Daily
Federal Reserve Chairman created a stir a few weeks back when he said that the progressive decline in yields on long-term bonds at a time when the central bank was gradually tightening monetary policy posed something of a “conundrum.” Market participants took that to mean that Greenspan was surprised that long-term interest rates had gone down, including mortgage rates, and that was keeping the American economy stronger, especially the red-hot housing market, than otherwise.
People vaguely recollect coming across the word “conundrum” when they were studying for the SAT college entrance test. Most have never used it at all. Because it is not a commonly used word, that gave it more prominence than alternatives such as “tricky problem” or even “puzzle” would have. Even the dictionary has trouble deciding what it means. The Merriam-Webster entry offers three choices: 1: a riddle whose answer is or involves a pun; 2 a : a question or problem having only a conjectural answer b : an intricate and difficult problem.
Probably the last definition that fits best. But the Chairman chooses words carefully. He might have been intrigued by the middle choice. No statistical analysis can unequivocally resolve the question of why the bond market improved in the face of a 2 percentage point increase in short-term interest rates. It is certainly a very rare occurrence. We can only conjecture – that is, guess -- why it happened.
What I find most intriguing, and maybe Greenspan does too, is that the past year or so has been unique in terms of economic forecasts. I can’t recall a period in which the consensus of both private and official forecasters has done any better in predicting GDP growth. But if you look at the long-term interest rate predictions that accompanied these growth forecasts, they have all been too high.
To try to unravel the conundrum, it’s worth starting with a simple observation: there are basically two kinds of investors. The first type includes “buy-and hold” investors. Most individuals and many financial institutions fall in that category. They normally have a target rate of return that they seek. They buy securities like stocks and bonds and rarely trade them.
The second type is made up of “total rate of return” investors or “performance-based portfolio managers.” The most aggressive, and most highly publicized, in this category are hedge funds. But many enterprises, including traditional commercial banks and the financial departments of industrial companies, contain units that try to make profits by operating in this manner.
What do the two different classes of investors do when long-term interest rates fall and bond prices rise? The buy-and-hold investors tend to do nothing. They could sell the bonds they own at a profit, but then they would be left with the thorny problem of where to invest the proceeds. So they tend to keep them.
By contrast, total rate of return investors mark their portfolios to market every day or week. They view the decision to hold onto bonds they already own as if it was a decision to buy them anew. This biases them toward active trading, buying and selling securities every day or week and certainly every month, as their interest rate expectations shift.
If we ask which group has been accumulating US Treasury securities over the past year or so, the data clearly shout out: buy-and-hold investors. The biggest buyer of US government bonds has been foreign investors. The majority of those purchases have been made by buy-and-hold investors, including central banks, government-owned financial institutions, and private foreign investors such as insurance companies. US investors have bought relatively little. But most of those purchases have also been by buy-and-hold investors, rather than the prominent “total rate of return” investors that populate Wall Street. In fact, broker-dealers have been net sellers of US Treasuries almost continuously since 2003.
Financing the US Government
| $ billions at annual rates | 2004 | 2005 Q1 |
| US Treasury Securities, net issues bought by: | 362.5 | 606.0 |
| Foreign official institutions | 261.5 | 59.8 |
| Foreign private investors | 95.7 | 312.7 |
| US households, directly | 35.2 | 86.1 |
| US banks | -22.8 | 50.2 |
| US monetary authority | 51.2 | -17.6 |
| US insurance companies | 12.7 | 9.3 |
| US pension funds | 7.6 | 10.6 |
| US mutual funds, hedge funds. Etc. | -23.7 | 42.6 |
| US broker-dealers | -82.4 | -36.9 |
| All other, incl. state & local governments | 89.2 | 27.5 |
Against a backdrop of solid US economic growth and mild inflation, foreign investors have been happy to add to their already huge holdings of US Treasury securities. Most are not inclined to trade their portfolios actively, even when they could realize sizable capital gains on their profitable positions. They are simply not out to maximize total rate of return; they have other objectives. The steady increases in US short-term interest rates resulting from the Federal Reserve’s monetary policy tightening have not shaken confidence. Indeed, the Fed’s rate hikes may have strengthened investors’ resolve to buy and hold. In a more speculative bond market, things would have been a lot different, and Fed tightening would almost certainly have caused a big rise in bond yields.
Certainly, it is possible that investor confidence could be shaken by future economic or political developments. But not in the trusting environment of the past year or so.
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