International Capital Flows and U.S. Interest Rates

What affect, if any, do international capital flows have on long-term interest rates within the U.S.?:

International Capital Flows Alter U.S. Interest Rates, by Les Picker, NBER Digest: There is a burgeoning literature on the impact of international capital flows on emerging market economies. ... In contrast, much less is known about the impact of capital flows on the larger economies of the world. ...[U]ntil recently, many market participants held the view that capital flows could not possibly affect interest rates in the United States.

In International Capital Flows and U.S. Interest Rates (NBER Working Paper No. 12560), authors Francis Warnock and Veronica Warnock ... ascertain the extent to which foreign flows into U.S. government bond markets can help to explain movements in long-term Treasury yields.

The authors address this issue at an important time. ... Over the course of 2004, the Federal Reserve began a well advertised tightening that raised short rates while economic growth strengthened and inflation picked up. Many market observers predicted an increase in long-term U.S. interest rates that would result in substantial losses on bond positions. However, long-term interest rates remained quite low, puzzling market participants, financial economists, and policymakers.

The authors find that foreign flows have an economically large and statistically significant impact on long-term U.S. interest rates. Their work also suggests that large foreign purchases of U.S. government bonds have contributed importantly to the low levels of U.S. interest rates observed over the past few years. In the hypothetical case of zero foreign accumulation of U.S. government bonds over the course of an entire year, long rates would be almost 100 basis points higher. Were foreigners to reverse their flows and sell U.S. bonds in similar magnitudes, the estimated impact would be doubled. Further analysis indicates that roughly two-thirds of the impact comes directly from East Asian sources. In addition, some of the foreign flows owe to the recycling of petrodollars, suggesting a mitigating factor that might be reducing some of the bite of higher oil prices. ...

Comments

[Lafayette]

EV: "In contrast, much less is known about the impact of capital flows on the larger economies of the world. ..."

Not really. All you have to understand is that the dollar is a reserve currency and that trading nations are willing to keep the dollars that they earn. For as long as they keep dollars, and re-lend them, interest rates are lower (than otherwise).

The day that they decide that the dollar is no longer worth keeping, they will dump them. They will sell it to whomever is willing to buy them, meaning that the dollar will depreciate. This simply provokes even further dollar dumping. As you increase the aggregate supply of money, which is losing value, then banks must also increase its yield in order to compensate.

In the wake of this dollar tsunami, interest rates could very well skyrocket.

Note also that, in order to spread the risk, more and more countries are dispersing their reserve currencies by adding Euros and ... the Chinese Yuan. The US has had a "reserve currency" advantage since WW2, which is constantly being eroded.

Is the moment arriving when the piper must be paid? Or, will Americans continue to believe the idiocy uttered by thier VP, that "Deficits don't matter. Nixon proved that."

[ilsm]

Foreign capital flows are important.

What about the impact of the intragovernment debt, about 43% of the total US federal debt?

If the US government were not collecting far more in fees and Social Security employment taxes than was going out what would interests rates be?

What would aggregate demand be? I the the working guy kept a third of what is now taxed in SS?

The touted $315B deficit in 2005 was merely the need for more privately held debt and does not reflect the increase in intragovernment debt which financed about $216B of the cash shortfall from the receipt of income taxes.

[Felix]

Lots, lots more on this subject here.

[Ken]

an interesting note. Greenspan this week voiced some concern regarding protectionism.

http://news.yahoo.com/s/nm/20061026/us_nm/economy_greenspan_dollar_dc_4

This is a really interesting time. Unlike the trade deficts of the 80's. The post B Woods economy reacted well via the recycling petro-dollar and Japan's Growth spurt and intervention in the currency markets.

Now we are seeing a transitionary phase where the US is less dominant. The question is will we see deficits translate into higher interest rates. Will it become an issue of who can offer the best yield in a Eurozone vs. the US in the debt markets?

[knzn]

I can’t evaluate this because I don’t have a NBER subscription, but based on the explanation here, I’m a bit skeptical. It sounds like they are taking foreign capital flows (including the composition thereof) as exogenous. But if foreigners were buying short-term assets (e.g. 3m Treasuries), then it clearly wouldn’t have a direct effect on interest rates, because the Fed would counteract it. If they are choosing instead to buy longer-term assets, it is presumably because they have a good reason for doing so, and domestic buyers might well have the same good reason if the foreign demand weren’t already driving up prices.

[calmo]

knzn, the Warnock and Warnock paper referred to in the NBER digest is found by visiting the Setser link provided by Felix.
Setser defends his claim (foreign purchases of tbills have lowered long term interest rates by 150-200bp) that Rubin questions on rather opague data. It is understood that long term tbill purchases are their focus, just not clear who and how much.

[Lafayette]

knzn: "But if foreigners were buying short-term assets (e.g. 3m Treasuries), then it clearly wouldn’t have a direct effect on interest rates, because the Fed would counteract it"

Oh, and how would the Fed do that? Abracadabra?

This phenomenon (of current account deficit dollars being recycled into the American economy by means of T-bill purchases by China) has been happening for at least 5 years. At least.

The Fed has been "countering it"? How? Continually tweaking the discount rate? No way, José.

[anne]

Long term bonds have returned better than 8% a year over the last decade, while the dollar has lost only 2.95% in value against developed market currencies. Whether for international or domestic investors, long term bonds have been a fine investment. Going forward returns will be lower, since the starting point of interest rates on long term bonds is now lower, but there has been reason to hold American bonds for quite a while. I never understand why this is surprising.

[anne]

There are all sorts of structural economic problems, especially problems of wages and benefits due to relative labor weakness, but the long term bond market gives me a sense that the general economy is just not that vulnerable. I am quite cautious, but believe a recession is avoidable given my reading of the attractiveness of low long term interest rates for investors or the corresponding cushion for borrowers.

[Lafayette]

anne: "Long term bonds have returned better than 8% a year over the last decade, while the dollar has lost only 2.95% in value against developed market currencies."

The dollar was at $0.85 to the Euro three/four years ago. It went up a high as $1.33 and is now down to about $1.27.

That devaluation is significantly more than ... er, 3%, particularly as regards a major trading partner, the EU (ex-UK).

[Lafayette]

anne: "but the long term bond market gives me a sense that the general economy is just not that vulnerable"

Ooooppsss ....

"A falling speed limit"
Oct 26th 2006
From The Economist

America's long-term rate of growth may be slowing; that will make its economy harder to run

THE world is used to the idea that America's economy grows much faster than Europe's, because that is the way it has been for many years. But it may not be that way for much longer. Just as European growth seems to be picking up, perhaps to over 2% a year, America's appears to be heading downwards to not much more than that.

In the short term America's economy is certainly slowing, as the latest GDP figures, due out on October 27th, are expected to show. But the more worrying data concern the longer term. America's economic speed limit—the pace at which the economy can grow without fuelling inflation—is also dropping. It may soon be as low as 2.5% a year, by some estimates the slowest pace in more than a century.

Watch that accelerator

An economy's potential or trend rate of growth depends on the supply of workers and their productivity. The productivity boom that began in the mid-1990s pushed America's trend growth rate well above 3% a year. Now it is falling, both because the productivity surge is fading and because the supply of workers has slowed (see article). The baby-boomers are approaching retirement. Women's rush into the workplace has at least slowed, and may have reversed. Teenagers are working less. And hostility to immigration, another source of labour, is rising: witness the barriers along the Rio Grande.

Any fall in America's economic speed limit will have serious consequences. Financial markets could be rattled as investors lower their expectations for future profit growth. American assets may look less attractive to foreigners. And economic policy will become decidedly more complicated.

It will be particularly awkward for central bankers. America's underlying inflation rate is already uncomfortably high. For inflation to fall, the economy needs to grow below its trend rate, but if that rate is dropping, the Federal Reserve's task becomes harder: raise interest rates too far and recession looms; do too little and inflation worsens. The failure of central bankers to recognise that the economic speed limit had dropped was one reason why inflation spun out of control in the 1970s. Fortunately, their successors seem determined not to repeat that mistake. Some evidence suggests the Fed's officials are lowering their estimates of potential growth faster than many on Wall Street. At their policy-setting meeting this week, the central bankers kept short-term interest rates unchanged at 5.25%, but repeated their warnings about “inflation risks”.

Politicians' lives will get harder too. Slower growth means less tax revenue and a darker fiscal outlook. Official estimates of America's long-term budget problems, such as the shortfall in the Social Security pension system, may not change, since they are already based on very gloomy assumptions about productivity growth. But if productivity growth slows and a smaller share of people work, the burden of paying for the health care and pensions of the baby-boomers will increase.

Reforming health care and pensions will therefore become more urgent—but also harder. Slower growth tends to sour the political environment. Populist solutions gain appeal. There is a danger that, instead of pushing policies that boost America's potential (such as encouraging old folk to work longer, boosting the number of immigrants and freeing trade), politicians will turn to easy protectionist solutions. Which would, of course, slow the economy further.

[anne]

No; I expressly wrote about the dollar over 10 years. The dollar goes up, the dollar goes down, but is almost unchanged over 10 years and this has been so for years of rolling 10 year periods. Now, I expect the dollar will lose value in time and invest accordingly but I have no idea when and I am not the least concerned.

[anne]

What the "Economist" writes about America is of little interest to me, but thanks for the essay. When the Economist writes about the material consequences of Iraq, I will pay more attention to the warnings about America. I must leave now for a while, and will continue.

[calmo]

I'm no fan of The Economist either anne but this particular article (thanks Lafayette) was worth reading and worth addressing (this means you, L, might comment in addition to pasting).

[Lafayette]

"When the Economist writes about the material consequences of Iraq,"

Well, then I suggest you look for another blog.

I am against the Iraq intervention, but everything in its place, and a place for everything.

[anne]

Now, let me make clear that there is almost no line in the "Economist" article I agree with. This sort of tendencious demographic the-sky-is-falling we are allowing no one to grow old anymore writing both bores and irritates. Happily, though, we are no longer a colony of Britain and the colonialist analysis of the Economist for America as well as for China is easily dismissed.

The prime structural problem for the American economy is a gradual continual loss of balance for American workers reflected in relatively sluggish wage and increasingly limited benefits especially health care.

We are in the process of tragically wasting from $1 to $2 trillion dollars in Iraq, and therein is at least as serious an American economic problem as any of the folishness considered by the neo-colonialist Economist. When the Economist figures out there is a lunatic tragic war and occuption to deal with before preaching about an aging America, let me know.

How is that, for a start?

[anne]

Lafayette, you are a gem for presenting the "Economist" article no matter my complaint and I read the article carefully as you well deserved. But, there is assertion on assertion with only cliche support. Demographic analysis in economics is so difficult, and I enjoy complaining about the Economist as you can tell. I complain about Tony Blair, as well. We need to look to Europe in demographic matters, and use our strengths in borrowing from Europe, as in health care and other social benefit programs. We have strengths in ethnic and cultural intergration, and in higher education and productivity.

[bsetser]

knzn -- Central banks are not just buying bills. They are big players in the market for notes with residual maturities of between 1 and ten years (See the treasury survey of holdings -- or email me and I'll send you some proprietary RGE stuff comparing the maturiry distribution of central bank holdings of treasuries with the outstanding stock; the results surprised me a bit). Certain central banks are also active in the market for longer-term agencies and MBS.

[anne]

Brad Setser:

"Central banks are not just buying bills. They are big players in the market for notes with residual maturities of between 1 and ten years...."

But, from an investment stance this has made perfect sense and has been evident in looking to bond market reflections. For bond holdings that will in effect be long term, always buy long term bonds. This strategy would have been proper for core bond holdings for any investor institutional or otherwise these last 30 years.

[anne]

What long term bond holding by Central Banks means to me is sensible investing. What troubles me is the extent to which so many institutional and private investors who have permanent bond portfolios that are not readily traded have not understood this these 30 years. Warren Buffett and Charles Munger explained this long ago in a speech to institutional investors I was told about. Even the wonderful John Bogle was slow to understand, but of course did.

[anne]

An institution that understand long term bond holding early on was AIG, though there came to be other problems for AIG. The reason I refer to 30 years is about 30 years ago investors were just beginning to understand what "duration" really meant.

[anne]

Also, I really do think the time has come to be angry about willful blindness that allows for economic analysis that does not so much as mention the terrible waste of a wanton trillion dollar war and occupation; a wanton $2 trillion dollar war and occupation.

I can save and conserve for the rest of my life, and the heck with ever wasting a fig, but this will not compensate for what we have squandered in Iraq, before the agonizing physical, psychological and moral casualties.

Get it "Economist," or is the point there the lunatic borrowed neo-colonialist grandeur of Tony Blair? [Is she ever tough.]

[Lafayette]

calmo: "this means you, L, might comment in addition to pasting)"

The post was a response to Anne's comment "Now, I expect the dollar will lose value in time and invest accordingly but I have no idea when and I am not the least concerned."

Anne is NOT concerned, and if concerned it is for her own personal investment account.

This is the typical hubris American's show when faced with economic uncertainty. (Perhaps it's couple with a blind faith that God will intervene, as usual, to protect his "chosen people"?)

My point has been consistent: The paradigm has significantly changed and the US, in it self-indulgence, is focusing on factors that are not pertinent to the problem at hand - the lack of an industrial dynamic that will assure that jobs created do not dislocate to foreign climates to make "stakeholder" fatcats even fatter.

This simply generates a bipolar social structure with an enormous cleavage between the "haves" and the "have-nots". How much economic evidence do you need that this happening? Already, research shows that 80% of the wealth generated goes to 20% of the population.

I was pleased when Communism was shown to be a false hope. I was less pleased when Katrina showed the world that a country fixated on wealth accumulation can be bent on policies that spend monies on senseless foreign wars or, actually, reduce the tax burden on those who have no need whatsoever for additional revenues - to the detriment of a yet significant part of its population in poverty. And some in abject poverty. Shame on you.

You people are scared s***less that al Qaeda will show up in your back yard, when the chances of that happening are about as remote as bin Laden hiding on the moon. The exagerrated expenditures on the DOD, coupled with the lack of a decent social support structure for the poor, is a problem that will hound you for the rest of this decade.

Comments please.

[Lafayette]

anne: "Now, let me make clear that there is almost no line in the "Economist" article I agree with. This sort of tendencious demographic the-sky-is-falling we are allowing no one to grow old anymore writing both bores and irritates."

Most clear, Madame. No doubt. It scared the hell our of chicken little too.

But, that does not mean that the Economist is wrong. Your denigration of the article contains no viable refutation of the facts represented and as interpreted.

The Economist has been around for more than a hundred years and its longevity was NOT assured by fanciful or Cassandra-like thinking. However, neither is the self-delusion of denial a suitable departure towards remedy.

[Lafayette]

anne: "We are in the process of tragically wasting from $1 to $2 trillion dollars in Iraq, and therein is at least as serious an American economic problem as any of the folishness considered by the neo-colonialist Economist."

The Economist has had a go at exaggerated DOD expenditures, probably on a week when you were sunning at the beach.

It consistently rails against Britain's participation in the folly. Tony Blair was naively credulous to believe possible the quid pro quo that he had hoped to obtain from Bush2 - namely, that in exchange for a quick win in Iraq, Bush would support the Palestinian cause of statehood (by pressuring Israel). Bush never delivered, and Lebanon2 was the result - and worse is to come from Israel in Gaza.

Read the damn magazine before complaining.