Mortgage rates in the US are determined by the yield on ten-year Treasury bonds.
That means that if foreign central bank buying – such as a number of Asian banks are currently doing – drives down the yield on Treasuries as bonds are being soaked up by these countries, it will make mortgage credit cheaper, giving new impetus to the bubble in US real estate. Which in turn will create more consumer borrowing capacity, stimulating consumption. That in turn will inflate the foreign trade deficit even further, but also lift tax revenues and cause the budget deficit to shrink much more than currently expected, reducing official bond issuance.
“If the US current account (deficit) continues widening faster than the US budget deficit,” FinanceAsia.com’s Richard Duncan says, “it could drive down yields on government bonds and therefore the interest rates on mortgages so low that it creates an asset bubble in the US that the Fed could not control.”
Foreign investors currently own about half the $4 trillion in US government debt held by the public. On reasonable assumptions, “within four years foreign investors could end up owning all outstanding US government debt.
“After that, they would have no choice but to invest their annual surpluses in other dollar-denominated assets, such as agency debt, corporate debt, equities, property, bank loans, etc.
“Such a scenario would cause extraordinary asset price inflation.”
And not only in the US. “When investors diversify out of dollars and into euros, for instance, they then invest… in euro-denominated debt instruments and thereby push up bond prices and push down bond yields in Europe. This explains why German government bond yields are currently at a 109-year low.”
Among the bullish analysts who have recently been setting challenging targets for government bonds are Bill Gross, who runs America’s biggest bond fund, and Christopher Wood of the Hong Kong-based investment bank CLSA.
Gross says ten-year Treasuries, now yielding just over 4.1 per cent, could go as low as 3 per cent within the next three to five years. Christopher Wood reckons that coming deflation will eventually drive down the Treasuries to a yield of 2½ per cent, or back to where it was in the 1950s.
By Martin Spring in On Target, a private newsletter on global strategy