The Bond Market Conundrum

How much does foreign central bank crowding-in lower U.S. bond yields? Brad Setser speaks:

RGE - The impact of central bank demand on US bond yields.: In late 2004 and early 2005, Nouriel and I estimated that the actions of foreign central banks might be holding US yields down by as much as 200 bp. That estimate found its way into Pam Woodall’s Economist Survey. And it then caught former Treasury Secretary Rubin’s eye. Robert Rubin is a wise and cautious man. He didn’t want to endorse the results of work that he hadn’t personally evaluated. So he qualified his remarks by noting:

I read something the other day (probably from the Economist) that -- if it were not for the inflow of capital from abroad -- our long-term interest rates would be as much as 200 basis points higher. I don't know who did the work or how accurate that is. But you may have had a distortion of the bond market by these vast inflows.

Rubin caught us. The 200 bp call didn’t emerge from careful empirical work. It represented our best judgment at the time. Back then there hadn’t been all that much empirical work on the question. And some of that work had found effects that seemed much too small, given the scale of central bank intervention.

Subsequent empirical work, I think, has been reasonably kind to our initial judgment.... Remember, the 200 bp estimate was made in the fall of 2004 and in early 2005 – back at the peak of the “conundrum.”.... That also was back at the peak of foreign central bank demand for Treasuries. I think it is reasonable to conclude that an awful lot of that demand came from the Bank of Japan, acting on behalf of the Ministry of Finance. Other central banks do buy Treasuries, of course, but many do so in ways that don’t register quite as cleanly in the US data (see below).

Moreover, our estimate explicitly included both the direct and indirect effects of central bank intervention.

The direct effect is obvious. Central banks have been intervening in the foreign exchange markets of the world at an unprecedented pace over the past few years – and as a result, they have a ton of dollars and euros that they have to invest. And they generally invest those funds in relatively safe bonds – whether Treasuries, Agencies, of Euro-denominated bonds of comparable quality (one interesting side note: the Italians are the biggest source of supply of euro-denominated government bonds, and, well, they aren’t exactly the best of all euro-denominated sovereign credits – something that may contribute to the dollar’s enduring popularity).

The indirect effects are more amorphous and harder to quantify.

Expectations of central bank intervention shape the actions of private market participants. This is most obvious in Japan. Japan has a history of intervening heavily to keep the yen from strengthening (too much). If market participants expect Japan will act that way in the future, they will be more comfortable borrowing yen to buy higher-yielding assets abroad. After all, the big risk of such a trade is a sharp appreciation of the yen. And if the ministry of finance won’t let that happen, the carry trade becomes more attractive. Think of it as government action that reduces the risk of a “fat tail” kind of outcome....

That argument can be generalized. The fact that central banks stand ready to buy dollars and dollar-denominated bonds if private investors aren’t willing to buy (enough) of them to finance the US deficit makes private investors more comfortable holding dollars and dollar-denominated bonds. Ask PIMCO. All their forecasts are premised on the continuation of the “Bretton Woods” system.

More generally, by keeping their exchange rate weak, the central banks of countries like China held down the price of their exports and thus the price of many imported goods, That helped keep inflation down in the big advanced – and increasingly housing and consumer-drive economies....

Quantifying these indirect effects is hard. It isn’t obvious to me that there is any real way to gauge how expectations about central bank behavior have shaped private expectations. I don’t know of anyone who has seriously tried. At the same time, I think many in the markets accept that central banks are now shaping their own activities (Ken Rogoff has a few colorful quotes).