With the 10-year Treasury yield ((^TNX), (IEF)) testing a critical technical and psychological support level at around 2.0%, many are wondering: How low can 10-year Treasury yields go?
Could 10-year Treasury yields ever fall below zero? What does history have to teach us on this topic?
10Y Treasury Bonds and Money Markets
Many investors will note that that yields on short-term Treasury securities have registered negative yields on several occasions in recent times. Could this happen in the case of 10Y Treasuries?
In a panic, yields on short-term government securities can and do become negative for very short periods of time as investors liquidate risky investments in exchange for money. Sub-zero rates can arise briefly because money market funds that receive this liquidity must invest the proceeds in money market instruments. Therefore, excess demand for these instruments can cause their price to be bid up to the extent that the yield on the instrument becomes negative.
As I have described elsewhere
, money market funds and other investors searching for places to store liquidity do not and will not purchase long-term Treasury bonds at negative nominal yields.
People that need to safeguard cash are looking for two things: First, they demand guaranteed principle integrity. Second, they demand instant liquidity. The rate of interest paid is a secondary or tertiary consideration in money markets.
Long-term Treasury bonds do not meet the criteria demanded by money market investors. Long-term Treasury Bonds are not money substitutes because of their long maturities and the associated risk of loss on principle.
Could a crush for liquidity ever reach the extent where money market investors were forced to climb the maturity ladder to avoid extremely negative rates at the short end of the curve? No. There are two reasons for this.
First, the sale of non-money assets for money is always a zero-sum transaction as far as the supply and demand for money and money substitutes is concerned -- i.e. somebody must part with their money (that is, withdraw a deposit or redeem shares in a money market fund) in order to pay the seller of the non-money asset. This means that the total net demand for money market instruments cannot really be altered very substantially. The only major exception to this basic observation arises if the Fed expands the money supply dramatically to meet the massive new demand for money. This possibility will be addressed below.
Second, the U.S. Treasury would not allow the demand for money to substantially exceed the capacity of money markets to absorb that liquidity. The Treasury, in coordination with the Fed, would issue as many short-term Treasury securities as would be required to equilibrate the supply and demand for money market instruments. The Prospect of Deflation
What of the possibility of severe deflation? Is it not possible that the prospect for severe deflation could prompt long-term bond investors to accept negative nominal yields knowing that their return could be positive in real terms? No.
First, there is absolutely no historical precedent for investors accepting negative nominal yields for long-term debt securities.
Second, nobody can reasonably believe that the U.S. Fed will ever allow deflation for 10 years – or the average rate of inflation over a 10-year period to be negative. As described here, the U.S. Fed will engineer inflation through proverbial “helicopter drops,” if necessary, in order to avoid prolonged deflation.U.S. History
In the history of the U.S., 10Y Treasury securities have never yielded substantially below 2.0% for any length of time. Indeed, aside from recent experiences in 2008 and 2011, the 10Y has never yielded anywhere near 2.0% except for a brief period prior to US entry into World War II.
As I have explained here
, if 2.0% has served as long-term floor for yields, there are powerful reasons to expect that this level will continue to hold. If 2.0% held under the gold standard and during times when the US had relatively lower debt levels, there is every reason to expect that it should hold under a fiat system and in the context of the country’s higher indebtedness.
The Japanese Experience
As thoroughly explained here
, I fully expect that the 2.0% psychological and technical support level for 10Y Treasury Bond yields will tend to hold in the U.S. (even if there are brief spikes below that level).
However, we may search for historical precedents outside the U.S. in order to imagine how low 10Y yields could conceivably go. Some analysts like to compare the current situation of the US to that of Japan in the past 15 years or so.
Recently, 10-year Japanese government bond (JGB) yields dropped to 0.995%, dropping below the 1.00% threshold. It is very important to note that this is only the third time that benchmark 10-year JGB yields have traded below the 1.00% level. The other two occasions were relatively brief periods in 1998 and another in 2002-03.
The 2002-2003 episode may be instructive. Between late 2002 and early 2003 a “bubble” developed in the JGB market. By May of 2003 the 10-year Japanese government bond (JGB) yields plummeted to an all-time low of 0.43%. This incident coincided with a massive “flight to safety” associated with a crash of the Nikkei-225 index
((^N225), (NKY), (OSA)) to a 20-year low.
What is instructive about this incident is that on June of 2003, Bank of Japan Chief Toshihiko Fukui moved to burst the JGB bubble. In a series of statements, he made it sufficiently clear that the BoJ would take steps to insure that JGB yields would rise. Three months later, the 10Y JGB yield had more than tripled, rising above 1.50%. The Nikkei-225 also rose from a low of 7,650 to above 10,000, based on the threat of BoJ engineered inflation.
The lesson to be learned here is that in a fiat monetary system, there are severe limits to how low government officials will allow inflationary expectations to go. There is therefore an associated limit on how low long-term bond yields can go.
Is The Japanese Experience Relevant to the U.S.?
For reasons described elsewhere
, the U.S. funding situation is not analogous. First, the U.S. savings pool is comparatively smaller in relation to its debt outstanding. Second, the U.S. funds its deficits in the context of highly fluid and relatively fickle financial markets as to opposed to Japanese savings that are more “captive.” Finally, U.S. policy makers have been clear that they will never allow the sort of deflation
that drove JGB yields below the 2.0% threshold. This in turn means that it is highly unlikely that bond investors will ever bid U.S. 10Y Treasury Bond yields down below that level.
In sum, it would not be reasonable to expect that U.S. 10Y yields could be sustained at the sort of low levels experienced in Japan.
How low can yields on 10Y U.S. Treasury bonds go? They will never go below zero. That may be less certain than death, but it is more certain than taxes. The US Treasury will probably cease to exist and taxes will stop being collected before 10Y yields drop below zero.
But, granted this absolute zero-bound threshold, how low can bond yields go? Historically, 10Y yields have never been sustained below 2.0%, or even near that level in the US. And, indeed, as long as the U.S. is on a fiat monetary system, there are overwhelmingly persuasive reasons to suppose that they will never be sustained at or below 2.0% in the future.
Japan offers a highly unlikely worst-case scenario for U.S. 10Y government bond yields. Yet, even this case offers lessons about how low long-term bond yields can go under a fiat monetary system. Even the case of Japan, with its enormous pool of captive savings, 10Y government bond yields have never been sustained below 1.00% for any substantial length of time. Based on the Japanese experience, 1.00% offers an absolute lower-bound estimate of how low 10Y government bond yields might be sustained for long periods of time.
Having said that, due to important differences between the U.S. and Japan, I believe that 2.0% will ultimately serve as the effective floor
for U.S. 10Y Treasury yields.
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