I can’t stand it any more! I read something interesting on the Internet and then have trouble finding it later! So from now on, I’m going to keep a list: International Capital Flows and U.S. Interest Rates, Francis E. Warnock, Veronica Cacdac Warnock.

Abstract: Foreign flows have an economically large and statistically significant impact on longterm interest rates. Controlling for various macroeconomic factors we estimate that had there been no foreign flows into U.S. bonds over the past year, the 10-year Treasury yield would currently be 150 basis points higher; even a step-down to average inflows would imply an increase of 105 basis points. The impact of the headline-making foreign official flows—a relatively small subset of total foreign accumulation of U.S. bonds—is also significant but markedly smaller. Our results are robust to a number of alternative specifications.

This is interesting, and one argues with Fed economists at one’s peril, but I have to wonder about another dimension: European long term interest rates are lower still than US, without much difference in inflation rates between the US and Europe. Would the authors think Euro inflows (which might also be high) are responsible, or is low global inflation the cause of low real long term interest rates?

My own not particularly rigorous research suggests real long term rates are positively correlated with the level of inflation, so changes in long term inflation rates have a double impact on both nominal and real rates. On the other hand, the paper (p13) ASSUMES real rates are stationary. Since real rates today are lower than average, then “something” has to be responsible, and the authors pickup the largest component different from recent history, which is foreign bond purchases.

An interesting question then, is which model of long term rates is more reasonable — stationarity or proportional to inflation (reflecting risk, volatility, etc.). Note that volatility of interest rates is also proportional to interest rates (and hence to inflation), so there is quite a bit of potential for factor confounding and correlation here.

Unfortunately, the authors do not report the correlation matrix of their “independent” variables, nor their measures of standard error of fit. It does seem like the addition of foreign flows to their models does not improve R2 by much (although R2 of 0.89 to 0.96 are pretty impressive, with or without foreign flows).

I also would have liked to see robustness evaluated by dividing the 22-year period into 3 or 4 sub periods rather than using overlapping periods that all include early data. This approach always appears to converge with decreasing error estimate bands.

Anyway, it was a very interesting paper. I hope the referees get them to increase the diligence on reporting standard error of fit, parameter correlation and use of sub-periods.

[…] Of course, that paper is nearly four years old now. In the interim, there have been expressions of regret for the disappearance of bond market vigilantes; this apparent disappearance is probably due also to indiscrimate buying by the Chinese as much as anything else. Also, probably, due to the fact that idiots such as myself, who have been saying for years that inflation of 2%-ish should mean Canadian 10-year-yields of 4.75-5.25%-ish have had our heads handed to us on a 3.75% plate. […]

[…] Sub-prime is old news, as evidenced by the fact that the IMF is pontifficating on the subject. The Europeans say investors can take their lumps anyway. Of far greater interest is rumblings from China that they may be willing, under certain circumstances, to flex their treasury muscle and use their currency reserves as a political weapon. Bush says that this would be foolhardy, and it’s therefore surprising that anybody is still taking the threat seriously. But … there is some concern the Fed doesn’t have the same influence over longer-term rates that it used to. Tom Graff has some comments and I have previously noted the effect of Chinese investment on Treasuries. Their trade surplus rose again in July, so they’ve got plenty of ammunition. […]