After closing at 0.53 percent in July 2020 the yield on the ten-year US T-bond moved relentlessly higher, closing on Tuesday, September 28, 2021, at 1.55 percent. There is a growing likelihood that the July 2020 figure of 0.53 percent might have been the lowest point.
How should we view this in the context of historical trends in bond yields?
First, it is important to consider the behavioral foundations of bond buying.
As a rule, people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods. This stems from the fact that a lender or investor gives up some benefits at present. Hence, the essence of the phenomenon of interest is the cost that a lender or an investor endures.
An individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means. The cost of lending or investing to him is likely to be very high—it might even cost him his life if he were to consider lending part of his means. Therefore, he is unlikely to lend or invest even if offered a very high interest rate. Once his wealth starts to expand, the cost of lending or investing starts to diminish. Allocating some of his wealth toward lending or investment is going to undermine to a lesser extent our individual’s life and well-being at present.
From this we can infer, all other things being equal, that anything that leads to an expansion in the wealth of individuals gives rise to a decline in the interest rate, i.e., the lowering of the premium of present goods over future goods. Conversely, factors that undermine wealth expansion lead to a higher interest rate. Observe that while the increase in the pool of wealth is likely to be associated with a lowering in the interest rate, the converse is likely to take place with a decline in the pool of wealth.
People are likely to be less eager to increase their demand for various assets, thus raising their demand for money relative to the previous situation. All other things being equal, this will manifest in the lowering of the demand for assets, thus lowering their prices and raising their yields.
Note again, that increases in wealth tend to lower individuals’ time preferences whereas decreases in wealth tend to raise time preferences. The link between changes in wealth and changes in time preferences is not automatic, however. Every individual decides how to allocate his wealth in accordance with his priorities.
Changes in Money Supply and Interest Rate
An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier than before the increase in the money supply took place. Hence, this will likely give rise to a greater willingness in these individuals to purchase various assets. This leads to the lowering of the demand for money by these individuals, which in turn bids the prices of assets higher and lowers their yields.
At the same time, the increase in the money supply sets in motion an exchange of nothing for something, which amounts to the diversion of wealth from wealth generators to non–wealth generators. The consequent weakening in the wealth formation process sets in motion a general rise in interest rates. This implies that an increase in the growth rate of money supply, all other things being equal, sets in motion only a temporary fall in interest rates. This decline in interest rates cannot be sustainable because of the damage to the process of wealth generation.
Conversely, a decline in the growth rate of money supply, all other things being equal, sets in motion a temporary increase in interest rates. Over time, the fall in the money supply encourages a strengthening of the wealth formation process, which sets in motion a general fall in interest rates. We can thus see that the key to the determination of interest rates is individuals’ time preferences, which are manifested in the interaction of supply and demand for money. Also note that in this way of thinking the central bank has nothing to do with the determination of the underlying interest rates. The policies of the central bank only distort where interest rates should be in accordance with time preferences, thereby making it much harder for businesses to ascertain what is really going on.
Assessing Historical Long-Term Yield Trends
From 1960 to 1979 the yields on the long-term US Treasury bond had been following a visible uptrend (see chart). From 1980 until now, the yields were following a downtrend (see chart).
From 1960 to 1979 we can also observe that the yearly growth rate of money supply (AMS) followed a visible uptrend (see chart). This caused a strong weakening in the wealth generation process on account of the exchange of nothing for something. The weakening of the process of wealth generation due to the uptrend in the growth momentum of money supply lifted individuals’ time preferences, and this placed the underlying long-term yields on a rising trend.