It all began with the “conundrum”: the disconnect between Fed-based short-term rates and long-term mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. In theory, long rates are the geometric average of expected future short rates plus the risk that increases with duration of the instrument. So tightening short-term rates should be followed by an increase in long-term rates, say the 10-year Treasury notes.
During previous monetary policy tightening cycles (88–89, 94–95 and 99–00), the 10-year Treasury yield (green line) responded to increases in the federal funds rate (purple line):
Short x Long
But during 04-05, there was no response. Fed rates went up but long term rates remained. Something different was happening then.
Back in 2005, before the Senate Committee on Banking, Housing, and Urban Affairs, Greenspan admitted his disbelief:
Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. […] For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.
Now, in a long Wall Street Journal piece, Alan Greenspan tries to convince us the Fed didn’t cause the housing bubble. He blames it on the global decline on long term rates rates (and thus mortgage rates as well) spawning the speculative euphoria. And the cause of this global decline? The fall of Communism and consequent rise of China:
U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
The presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble.
From 2002 until late 2004, foreign officials purchased millions in Treasury securities. More specifically, Asian central banks had consistently increased their holdings of foreign reserves while boosting exports, mainly to the U.S. An incredible economic growth led to record-high trade surpluses, that were in turn invested in U.S. and European Treasury bonds, compensating the usual effect of short-term rate hikes.
Foreign Purchases x 10-Year Treasury Yield