Thursday, October 17, 2013

Why Aren't Bond Yields Higher?

President Obama is speaking as I write this, and is repeating what is part of the conventional wisdom about the aftermath of the latest government shutdown.

Namely, the President believes that the sense of a disfunctional federal government is raising the cost of borrowing for the U.S. government.

While logical on the surface, the bond markets seem to be telling a different story.  Yields on U.S. Treasury notes are lower today than a month ago. In fact, as the chart above indicates, yields stand at roughly the same level as 2011, the last time we saw political brinksmanship over the federal budget.

What's going on here?

One explanation might be that while foreign creditors are very unhappy with the state of American politics, the fact remains that this country's debt market offers the safest and most liquid alternatives for foreign currency reserves.

China, for example, has been quite vocal about its concerns on the federal shutdown.  But as Ambrose Evans-Pritchard wrote earlier this week in the London Times, the Chinese were massive buyers of U.S. debt in the third quarter:

So much for the hot rhetoric from Beijing questioning the creditworthiness of US debt and consigning the US dollar to the dustbin of history.

The latest data shows that China's foreign reserves soared by $163bn in the third quarter to $3.66 trillion, one of the biggest jumps ever.

Mark Williams and Qinwei Wang from Capital Economic called the rise "astonishing". They estimate that China's central bank must have bought $70bn of foreign bonds last month in a frantic bid to hold down the currency.

We won't know for a while where the money went, but a big chunk must have gone into US Treasuries. So bear that in mind when you read the Xinhua claims that the US debt ceiling fight "has again left many nations' tremendous dollar assets in jeopardy and the international community highly agonised."

Meanwhile, famed bond manager Jeff Gundlach thinks that interest rates in the United States could stay long for a much longer time than most expect.

Here's an excerpt from a post on blog Business Insider:

However, {Gundlach} does not think that this means interest rates will surge in the near-term.

"One thing we know for sure is short-term interest rates will stay low for as long as the eye can see," he said, arguing that the Federal Reserve would have to end its quantitative easing (QE) policy first.

Considering that Vice Chair Janet Yellen is expected to take the helm of the Fed in January when Bernanke retires, Gundlach doesn't see QE ending "for the next few months."

So while Gundlach is bearish on U.S. government policy, he is no bear on the government bond market.