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NEW YORK (TheStreet) -- There are three major factors that will serve to keep U.S. intermediate and long-term interest rates low for 2015, and, perhaps, beyond:

• Alternative investments are unattractive

• Foreign central bank "quantitative easing" programs (also known as QE, asset buying programs by central banks designed to add liquidity to the market) will result in funds which will inevitably find their way into U.S. capital markets

• New U.S. bank liquidity rules are creating huge demand for full faith and credit U.S. assets

Alternative to U.S. Bonds

U.S. Treasury and agency rates are much more attractive than their competitive alternatives. The German 10 year bund now yields 0.7%; the French 10 year less than 1.0%; the Spanish 10 year less than 2.0% (this is BB rated = junk!). The U.S. 10 year currently yields somewhere near 2.30%.

If you were a portfolio manager and were required to hold sovereign debt, it is a no-brainer as to which one you would choose. Thus, as long as Europe is struggling with growth and that is playing the easy money game, U.S. Treasury intermediate term rates will be attractive. At the same time, if the U.S. budget deficit continues to shrink, the demand/supply cross will serve to push rates lower.

Foreign Central Bank QE

The Bank of Japan, The Peoples Bank of China, the European Central Bank and the Bank of England are all facing slow economic growth or outright recessions. They learned the value of QE from the Federal Reserve.

Over the past quarter century, the large U.S. budget deficits have been welcomed by a globalizing world. The dollar, after all, is the world's reserve currency and there must be enough of them to lubricate world trade. Over the years, the U.S. budget deficits, financed with IOUs (i.e., paper dollars), have become a deep pool of liquidity facilitating world trade. A transaction between a South Korean manufacturer and a Turkish purchaser is transacted in dollars -- but this transaction does not impact the U.S. economy or its GDP.

However, when a central bank, like the BOJ, decides to stimulate its economy by encouraging exports, it does so by creating money (yen) via QE and selling the newly created money in the foreign exchange market for dollars. Thus, the value of the yen falls thus making exportation from Japan (importation elsewhere) more attractive. The BOJ winds up with dollars after the foreign exchange transaction. They don't want to hold these dollars as a sterile asset, so they look for dollar investments. Give the alternatives discussed above, many of the dollars will flow to the U.S. seeking sovereign debt (Treasuries).

There are two impacts here:

1) The dollars came from the deep liquid pool of IOUs which serve to finance world trade outside the U.S. Now, some become repatriated and re-enter the U.S. money supply. This process is equivalent to the Fed continuing its QE3 program.

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2) The second consequence is that the demand for intermediate and long-term U.S. Treasury securities rises as these foreign central banks continue to print money. Thus, downward pressure is exerted on the intermediate and long-term areas of the yield curve.

New U.S. Bank Liquidity Rules

New U.S. bank liquidity rules begin phasing in during 2015. These rules are similar in concept to the risk weights which have been applied to bank assets for the past 20 years. For example, a loan to a private sector business requires that the bank have 20% of the loan in excess or free capital. However, the assets backed by the Treasury have no capital reserve requirement.

The new liquidity rules are similar. These new rules require banks to hold enough "highly liquid" assets (those which can be easily sold) for the bank to survive a 30 day period of intense stress (where liquidity dries up like it did in 2009). Like the risk ratings on loans, only full faith and credit U.S. government securities (Treasuries and Ginnie Maes) count 100%. Certain high quality corporate notes are counted at 50%. The result of these coming rules is that in the third quarter, bank holdings of Treasuries rose $71 billion, according to The Wall Street Journal. This was the fourth consecutive quarter of double-digit growth.

The Fed has always been the "lender of last resort." It was set up to be a source of liquidity during periods of financial stress. And, it has accomplished that function for more than 100 years -- the last two times in 2009, and in the late 1990s. These new rules, however, now force banks to self-insure as opposed to relying on the Fed. It's as if the Fed has pre-funded the next period of financial stress.

Whether or not you agree with what the Fed has done, the result is that, beginning in 2015, as the new rules phase in, the demand for Treasuries on the intermediate and long-term areas of the yield curve will increase dramatically; this puts downward pressure on the yield curve.


The relative attractiveness of U.S. yields, along with foreign central bank QE, and new U.S. bank liquidity rules all come together in a perfect storm to put significant downward pressure on the intermediate and long-term U.S. yield curve. If the Fed should decide to raise short-term rates in 2015, the yield curve may simply flatten.

For investors, some move toward intermediate term duration in their fixed income allocations may be of benefit in 2015.

The Fed, whether or not it did any of these actions intentionally has accomplished three things:

• It has financed the U.S. debt and deficits at extremely low rates;

• It has, in effect, tightened significantly (equivalent to huge increases in reserve requirements) what money banks could create based on excess reserves in the system. The textbook result of new reserves in a 10% reserve requirement regime (currently the case) is a 10 multiplier of those reserves. But new lending and now new liquidity rules have significantly reduced the ability of those reserves to multiply. The result is that the Fed has been able to accomplish its wealth effect (stock market gains) without much, if any, official inflation.

• The new liquidity rules pre-fund the next period of bank stress, make the banks self-insure, and relieve the Fed, itself, of any internal stress it may have in acting as the "lender of last resort."

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.