Why are US and European government bond yields so low? Dr. Mete Feridun Senior Economist CMPA-London

1. Why are US and European
government bond yields so low?
Dr. Mete Feridun
Senior Economist
CMPA-London

2. 10-year government bond yields

4. 1- Declining term premia
2- Reserve accumulation by foreign central banks
3- Overestimation of the output gap
4- Low inflation expectations
5- Low interest rates
6- Flight to safety
7- Monetary policies
8- Prudential regulations
Possible reasons

5. Declining term premia in US and UK
• Longer term bonds are riskier and require a “term
premium” to compensate for this extra risk
• Term premium is driven by the long-term risk outlook
and varies over time as interest rate risk and investors’
risk tolerance fluctuate
• US and UK bond yields are low as the term premium
has declined: Uncertainty about economic recovery has
improved and as inflation expectations has become
more stable

8. Reserve accumulation by foreign
central banks
• Over 30% of US government bonds are bought by foreign
central banks – they are “price insensitive”
• Chinese central bank has built up huge foreign exchange
reserves to offset the large current account surpluses
and prevent fast yuan appreciation - it has invested its
reserves in US Treasuries
• This has increased demand for US government bonds,
resulting in lower yields. Overseas central banks have
also been holding UK gilts for diversification

11. Overestimation of the output gap
• A narrowing output gap means economy has reached
its limits, and further growth will lead to inflation as
production and labor costs rise
• Higher inflation expectations damage attractiveness of
government bonds
• A wide output gap (or its overestimation) keeps
inflation expectations low, increasing attractiveness of
bonds

15. Expectations of low inflation
• Inflation erodes the value of coupon and principal so they
demand higher yields if inflation expectations are high
• Inflation expectations in EU and USA are very weak
• There is a strong disinflationary trend in Europe - main
fear is deflation and stagnation
• Rising US dollar has reduced inflation risks in US
• Low energy prices have kept inflation expectations low
everywhere

17. Low interest rates
• Central banks signal that the timing for their first interest-
rate increase will depend on how the economy performs
• Neither the Fed nor the Bank of England is expected to
start raising interest rates until the second half of 2015
amid contained inflation
• In the “new normal” state of weak growth and low
inflation, interest rates are expected to remain low
• Expectations of low interest rates in EU and USA makes
bonds more attractive as they are safer than deposits

18. • Low interest rates result in lower interest rates on the
newly issued bonds
• This protects the values of existing bonds
• Higher interest rates make newly issued bonds more
attractive to buy, reducing demand for existing bonds,
diluting their value
• So, low interest rates keep existing bonds attractive

21. Prudential regulations
• Regulatory capital adequacy requirements push financial
institutions to invest in less risky assets
• There has been a shift from risky assets into government
bonds by banks and other “liability-driven” investors
• Pension and insurance funds match their long-term
liabilities by with government bonds for a secure income
• Conspiracy theory: are governments are forcing savings
into government bonds to inflate away their debt?

22. Flight to safety
• Gilts and US treasury bond yields reflect investors’ confidence
in solvency of debtor countries amid few safe investment
opportunities - investors remain defensive in their investment
strategies
• In EU, government bonds are attractive as “safe heavens” as
austerity measures signal the commitment of governments to
balancing their respective fiscal accounts. Also, debts of
weaker member states ones have been guaranteed
• US bonds are particularly attractive due to yield differentials:
European and Japanese bonds offer below 2% on 10-year
bonds, US bonds, which are safer, offer of over 2%)

24. Monetary policies
• In the UK, BoE bought gilts as part of QE programme
irrespective of their price - this distorted the market and
sent prices higher and yields lower
• US is an exception where yields have risen during periods
of QE on the promise of recovery
• QE policies in USA, UK, EU and Japan have increased
liquidity and liquidity expectations and have kept interest
rates low - market do not “price in” a rise in interest rates