Why We Were So Wrong About 2005

Asia is awash with cash now, thanks to high savings rates and huge cash inflows from international trade surpluses. (That's the other side of the U.S. trade deficit.) This keeps interest rates low in these markets, and the huge movements of cash across international borders works, for now, to push U.S. interest rates lower.

Add in global demand for long-dated bonds, as private and public pension funds try to match their investments to their obligations to rapidly aging populations, and you start to get a possible explanation for the puzzle of rising short rates and falling long rates.

Euro Making the Dollar Look Good

What remains especially unclear now is what role expectations for an economic slowdown play in keeping long-term interest rates relatively low around the globe. That's a traditional interpretation of low long-term bond yields: When investors think the economy is about to slump, a move that will drive down the demand for money and consequently lower the interest rates borrowers are willing to pay, they buy today's bonds with today's higher yields in anticipation of tomorrow's lower interest rates.

This has the effect of driving down today's rates as well. But Greenspan recently told Congress that, this time, lower long-term yields may not be a signal the bond market is anticipating an economic slowdown. May not be. In other words, he doesn't know either.

The argument at the beginning of 2005 for a weaker dollar and higher U.S. interest rates was based, in good part, on a belief that international investors were becoming gradually unwilling to hold an ever-increasing supply of U.S. dollars. That unwillingness started to show up earlier this year in announcements from Asia central banks that they were thinking about reducing their portfolio concentration of dollars in favor of other currencies.

Haven't heard much talk like that since the euro's political crisis, have you? My best estimate now is that we won't see a significant upward trend in the yield on the U.S. 10-year Treasury until 1) the euro stabilizes and then starts to climb again vs. the dollar, and 2) the spread between the yield on the 10-year and two-year Treasury note vanishes. Today, the 10-year yields 3.9%, and the two-year yields 3.6%; this is an extraordinarily small spread. It's likely explained by the global need by pension funds for long-dated paper.