Why yields on American Treasury bonds so low?

I just read a bunch of articles on the current message of the markets. To summarize, U.S. economic growth is starting to dampen amid rising short-term interest rates, falling long-term yields, and a roller-coaster of a stock market. It's strange that long-term rates are falling when the Fed is increasing short-term rates by targeting the funds rate (The Fed increases the funds rate as a signal of inflationary pressures). But this is happening because people are still skeptical about future economic prospects due uncertainity over the outcome of the election, future of Iraq and rising oil prices. The industries that are hit the hardest by rising oil prices are airlines, transportation and financial services.

In the past three months, Treasury bond prices have been rising and their yields falling amid concerns of rising oil prices, uncertainty over the election, and the future of Iraq. Additionally, short-term interest rates are increasing, thereby flattening the gap between long-term and short-term interest rates.

But what makes the latest quarter unusual is that bond yields (long-term) fell even while the Fed continued to raise its target short-term interest rate to reach its current 1.75%. That is atypical. Usually, when the yield curve flattens, it is in the context of rising rates - short-term rates rising by more than long-term rates.

The yield curve plots the relationship between Treasurys of different maturities, with the benchmark referring to the spread between the 2-year and 10-year yields. Bond yields tend to move up and down with the economy. Because employers find it harder to fill jobs when the economy speeds up, wage pressures rise, and inflation often follows. To stop inflation from rising out of control, the Fed typically raises its short-term rates (the federal funds rate). Bond traders try to anticipate the movies, demand a higher yield to hold securities with a fixed payment (the fixed payment stays the same and does not increase with inflation). Therefore, the price of existing issues goes down.

One reason for bond-market strength has been that people are using bonds as a parking place for money they are reluctant to risk spending in the stock market. Even though, American shares have fallen only a bit this year, on September 29th, the Bureau of Economic Analysis (BEA) announced that corporate profits in the U.S. fell by 0.7%, after tax, in the second quarter compared with the first.

In light of these reports and other weak economic date (confidence, employment, inventories), if investors become more skeptical about the economy – as they did last quarter – they are more willing to buy bonds with lower yields. Already issued bonds will become attractive and go up in price (think demand and supply). The cycle of buying typically continues, reducing long-term yields and flattening the yield curve, until stronger economic data change investors’ minds and convince them that paying a higher price for a fixed return is no longer smart.

In the past, rising bond yields usually were associated with increase in oil prices. Rising yields indicated a stronger economy, which typically would provoke greater demand for oil. But in the past two months, oil prices have surged higher without much of a rise in the 10-year note’s yield. At the end of 2002, the 10-year treasury yield was around 4% and the price of oil was around $31 a barrel. Since then, the price of oil has risen more than 50%, but bond yields have been on a roller-coaster ride to nowhere.

What has changed: Oil and commodity prices in general are a small component of the U.S. economy that they used to be. Improved technology and productivity have combined with interconnected global labor markets to keep the costs of goods and labor relatively low, even when commodity prices are rising. Some economists also argue that oil-price increases today act as a consumer tax, curtailing spending, which because of its deflationary nature, actually has an opposite effect on bonds.

The worst-hit industries are the airlines and car manufacturers. This is because higher-fuel costs have increased operating costs while squeezing margins. So far this year, shares in airlines have fallen 23%, and the International Air Transport Association said on September 27th that, partly because of higher fuel costs, airlines would lose up to $4 billion this year. Similarly, higher oil price has increased the manufacturing costs of car companies while reducing the demand for sport-utility vehicles, which guzzle even more gas than the rest. Shares in car-makers are down by over a fifth this year.

But autos and transportation account for only some $200 billion of the $10 trillion market capitalization of the U.S stock market. But here is the biggie. Surging oil prices are very likely to have an impact on financial firm’s profits (currently financial firms make up of at least 40% of all corporate profits). The single most important determinant of the profits of financial firms is the steepness of the yield curve (the difference b/w short-term and long-term rates). A big part of the banking business is borrowing at lower, short-term rates, lending at higher, long-term rates and pocketing the difference. When the gap between long and short rates narrows, there is less to pocket, which is why a flattening yield curve long has been seen as a sign to sell bank stocks.

Also, there are to be sure, some factors distorting the market, in the form of big purchases of Treasures by Asian banks in general and the Bank of Japan in particular. For the last couple of years, Asian central banks have bought huge amounts of dollars to stop their currencies from rising. With those bonds they bought government bonds and bills, pushing prices up and so yields down a bit further than they would otherwise have gone. At the end of August, the Bank of Japan had some $122 billion in U.S. Treasuries.

Ultimately, low bond yields could help the economy since they help hold down other market interest rates, such as the rate charged for new, fixed-rate mortgages. Low market rates make it easier for consumers and companies to borrow and invest.

However, last quarter, American companies generated a financial deficit rather than a financial surplus (investment exceeded profits). Although the deficit was quite small, it is likely to get larger if profit margins fall further. This seems very likely. Consumers are too indebted, the trade deficit continues to widen, tax breaks are to be scrapped and the price of oil is rising.