Alan Greenspan: Central bank panel discussion
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, to the International Monetary Conference, People's Republic of China, Beijing, (via satellite),
6 June 2005.
* * *
The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a
200-basis-point increase in our federal funds rate is clearly without recent precedent. The yield on
ten-year Treasury notes currently is at about 4 percent, 80 basis points less than its level of a year
ago. Moreover, despite the recent backup in credit risk spreads, yields for both investment-grade and
less-than-investment-grade corporate bonds have declined even more than Treasuries over the same
period.
The unusual behavior of long-term rates first became apparent almost a year ago. In May and June of
last year, market participants were behaving as expected. With a firming of monetary policy by the
Federal Reserve widely expected, they built large short positions in long-term debt instruments in
anticipation of the increase in bond yields that has been historically associated with a rising federal
funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back
down. In March of this year, market participants once again bid up long-term rates, but as occurred
last year, forces came into play to make those increases short lived.
But what are those forces? Clearly, they are not operating solely in the United States. Long-term rates
have moved lower virtually everywhere. Except in Japan, rates among the other foreign Group of
Seven countries have declined notably more than have rates in the United States. Even in emerging
economies, whose history has been too often marked by inflationary imbalances and unstable
exchange rates, access to longer-term finance has improved. For many years, emerging-market
long-term debt denominated in domestic currencies had generally been unsalable. But in 2003,
Mexico, for example, was able to issue a twenty-year maturity, peso-denominated bond, the first such
instrument ever. In recent months, Colombia issued domestic-currency-denominated global bonds. As
rates came down worldwide, dollar-denominated EMBI+ spreads over U.S. Treasuries receded to
historically low levels, before widening modestly of late.
* * *
A number of hypotheses have been offered as explanations of this remarkable worldwide environment
of low long-term interest rates.
One prominent hypothesis is that the markets are signaling economic weakness. This is certainly a
credible notion. But periodic signs of buoyancy in some areas of the global economy have not arrested
the fall in rates.
A second hypothesis involves the behavior of pension funds. As the inevitable increases in retirement
populations approach, especially among developed countries, the underfunding of retirement plans
has become a growing concern. Pension funds and insurance companies, are being pressed to make
significant additions to longer-term bond portfolios. This demand for increasingly longer-term
obligations is evident in the favorable reception given the fifty-year-maturity bonds recently issued by
France and the United Kingdom.
But world demographic trends are hardly news, and recent adjustments to funding shortfalls do not
seem large enough to be more than a small part of a complete explanation.
The heavy accumulation of U.S. Treasury obligations by foreign monetary authorities is yet another
hypothesis that has been offered. And, doubtless, those purchases have lowered long-term U.S.
Treasury rates. But, given the depth of the market for long-term Treasury instruments, the Federal
Reserve Board staff estimates that the effect of foreign official purchases has been modest.
Furthermore, such purchases seem an implausible explanation of why yields on long-term non-U.S.
sovereign debt instruments are so low.
A final hypothesis takes as its starting point the breakup of the Soviet Union and the integration of
China and India into the global trading market, developments that have permitted more of the world's
lower-cost productive capacity to be tapped to satisfy global demands for goods and services.
Concurrently, greater integration of financial markets has meant that a larger share of the world's pool
of savings is being deployed in cross-border financing of cost-reducing investments.
The enlargement of global markets for goods, services, and finance has contributed importantly to the
favorable inflation performance that we are witnessing in so many countries. That improved
performance has doubtless contributed to lower inflation-related risk premiums, and the lowering of
these premiums is reflected in significant declines in nominal and real long-term rates. Although this
explanation contributes to an understanding of the past decade, I do not believe it explains the decline
of long-term interest rates over the past year despite rising short-term rates.
* * *
Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving
investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and
many other financial risks over recent years. The search for yield is particularly manifest in the
massive inflows of funds to private equity firms and hedge funds. These entities have been able to
raise significant resources from investors who are apparently seeking above-average risk-adjusted
rates of return, which, of course, can be achieved by only a minority of investors. To meet this
demand, hedge fund managers are devising increasingly more complex trading strategies to exploit
perceived arbitrage opportunities, which are judged - in many cases erroneously - to offer excess rates
of return. This effort is particularly evident in the pronounced growth and increasing complexity of
collateralized debt obligations. Although collateralized debt obligations are a powerful tool for
enhancing risk management by separating idiosyncratic risks from systematic risks, the models used
to price and hedge these instruments are just beginning to be tested.
I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of
pinpointing temporary market inefficiencies, the exploitation of which is expected to yield
aboveaverage rates of return. For the time being, most of the low-hanging fruit of readily available profits has
already been picked by the managers of the massive influx of hedge fund capital, leaving as a
byproduct much-more-efficient markets and normal returns.
But continuing efforts to seek above-average returns could create risks for which compensation is
inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a
point that recent data on the distribution of hedge fund returns seem to be confirming.
Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink,
and many wealthy fund managers and investors could become less wealthy. But so long as banks and
other lenders to these ventures are managing their credit risks effectively, this necessary adjustment
should not pose a threat to financial stability.
I trust such an episode would not induce us to lose sight of the very important contributions hedge
funds and new financial products have made to financial stability by increasing market liquidity and
spreading financial risk, and thereby enhancing economic flexibility and resilience.
* * *
The economic and financial world is changing in ways that we still do not fully comprehend.
Policymakers accordingly cannot always count on an ability to anticipate potentially adverse
developments sufficiently in advance to effectively address them. Thus our economies require, in my
judgment, as high a degree of flexibility and resilience to unanticipated shocks as is feasible to
achieve. Policymakers need to be able to rely more on the markets' self-adjusting process and less on
officials' uncertain forecasting capabilities.
The U.S. economy's response to the terrorist attacks of September 11, 2001, is a case in point. That
shock was absorbed by a recently enhanced, highly flexible set of institutions and markets without
significantly disabling our economy overall. But that flexibility should not be taken for granted, and
every effort should be made to preserve and extend it.
In this regard, the recent emergence of protectionism and the continued structural rigidities in many
parts of the world are truly worrisome. In the end, I trust that we will all recognize our common interest
in fostering global and domestic arrangements that promote the prosperity of our citizens.