Nouriel Roubini and Brad Setser have some highly recommended posts related to their research on unraveling the impact of foreign accumulation of Treasury securities on U.S. interest rates. Nouriel's post recaps his and Brad's gloomy forecast for the the bond market.
So, as we have been arguing, 2005 is likely to be the YOTGBM (Year Of The Great Bond Market Rout): we got a bond market rout in 1994 and another one in 1998...so 2005 sounds just right if a bit delayed (mid 2004 was just a minor scare) and given our twin and growing deficit the rout will be nastier this time around...
Brad's post provides an excellent summary of what the two of them have learned so far. If you are interested in this topic, you should read the whole thing, but here is the motivation...
Nouriel and I are working on a paper on "Bretton Woods Two," so I have been delving into some data on the Treasury market. No surprise: the goal is to see what we can learn about foreign central bank buying of Treasuries at different points on the yield curve, and thus try to figure out whether the "central bank bid" is one reason why the 10 year bond ended the year at 4.25% -- just about where it started -- even though the Fed tightened and inflation picked up.
And a key conclusion:
... I am pretty sure that central banks lent support to most of the yield curve. This data does not indicate whether foreign central banks are lending more support to the two year, the five year or the ten year bond, but they are lending so much overall support that it would be an enormous surprise if they were not lending substantial support to the ten year.
The capital account flows that Roubini and Setser are focusing on are, of course, just the flip side of the large U.S. current account deficits. You can find definitions of the current account and the capital account here, and a more complete, but very accessible, explanation in the article by Owen Humpage linked to in this post, but the idea is basically this: If foreigners send us more "stuff" (imports) than we send them (exports), they do not do so out of the goodness of their hearts, They expect payment in kind -- that is, in terms of real goods and services -- somewhere down the road. Thus, they accumulate IOUs that give them claim to U.S. production in the future. U.S. Treasury securities purchased by foreigners simply represent the accumulation of those IOUs. The net increase in those IOUs represent, by definition, a contribution to the U.S. capital account surplus.
In an earlier post, I argued that a reversal in U.S. current account deficits will likely result in rising interest rates. In other words, I have made very much the same argument from the current-account side of the coin that Roubini and Setser make from the capital-account side. In particular, I completely agree that large current account deficits. and the capital account surpluses they represent, have helped to keep U.S. interest rates low. I also agree that, as these circumstances reverse, interest rates will tend to rise.
Where do we disagree? I continue to be more sanguine about how disruptive this whole process will be. It is true -- when interest rates rise, bond prices fall, by definition. Some people call that a rout. I call it a plain-vanilla market adjustment.