Tuesday, March 3, 2009

On Treasury issuance and interest rates

This adds to earlier posts on the issue of whether the coming avalanche of Treasury debt issuance will push interest rates higher (or perhaps already has). This chart compares the amount of Treasury debt outstanding that is held by the public (thus excluding Treasury debt held by social security in a "lock box") as a percent of GDP, and yields on long T-bonds. Most people would guess that a big increase in the supply of Treasury debt outstanding would push interest rates higher, but the chart seems to suggest just the opposite. Treasury yields were at their lowest when Treasury debt was at its highest level relative to GDP during the 1940s, and yields were at their highest when Treasury debt was at is lowest level in the 1970s. And of course the big spurt in Treasury issuance in the fourth quarter of last year corresponded to a sharp decline in bond yields.

I think this adds up to a strong case for the argument that, within pretty wide-ranging limits, the amount of Treasury issuance has no meaningful or predictable impact on the level of interest rates. Interest rates are determined primarily by other factors, such as 1) inflation expectations, 2) economic growth, and 3) monetary policy. As I've explained before, bond yields are historically low today because over the next several years the market expects a) inflation to be very low or negative, b) the economy to be extremely weak (e.g., a big depression), and c) the Fed to be extremely easy. Those expectations add up to a convincing case in the market's mind that earning a risk-free rate of return of just 3% a year will likely be very competitive with other investment alternatives. That adds up to produce intense demand for Treasuries despite the coming avalanche of supply.


WilliamSSmith said...

Do you have the total debt (household, business, government, etc) to GDP number and or trend-line. It would be interesting to know what that trendline looks like as it relates to interest rates. Also, I don't pay too much attention to the post WWII numbers as it seems to me that the U.S. percentage of non-subsistence, non-slave productive capacity was so great that worldwide demand would drastically reduce the fraction.

Scott Grannis said...

There are lots of charts floating around that show total US debt to GDP in a rising trend over many decades. I don't focus on that since I don't think it is all that meaningful, as I explained in the comments to the debt service burdens post.

But I would note that despite an ever-rising total debt/GDP trend, interest rates have been trending down. Debt levels don't drive interest rates.

It is also reasonable to assume that debt levels can and should rise as an economy becomes more advanced and efficient, just as capital market theory says that companies operate more efficiently with some positive level of debt.