Interest Rate Outlook

Treasury Yields are Rising; and Why America's Relationship With China Matters for the Analysis

Sam Chandan PhD FRICS Real Capital Analytics and the Wharton School Following a lukewarm response to last week's Treasury note offerings, rates closed on Friday near their highest levels since last June. Just under $120 billion in 2-, 5, and 7-year notes were auctioned between Tuesday and Thursday. By Thursday afternoon, the 7-year rate had risen to 3.4 percent; the 10-year rate, to 3.9 percent.
Commercial real estate markets have benefited enormously from low short- and long-term rates over the last year and half. But over this time, the conduct of US monetary and fiscal policy has also prompted concerns about the potential for interest rates to rise suddenly. An imbalance in supply and demand for US Treasury notes is one reason why the accommodative risk-free rate environment could be upset. The rapid growth in issuance, a result of the federal government's wider deficit, has exacerbated concerns about whether demand can keep pace. In an interview last week with Bloomberg News, former Fed Chairman Alan Greenspan cited a historically "large buffer between the level of our federal debt and our capacity to borrow. That's narrowing." In explaining the smaller buffer, Greenspan pointed to the "huge overhang of federal debt which we have never seen before."  He called Treasury yields a "canary in the mine," in reference to the use of canaries as sentinels in coal mining operations. In this case, the supply of debt is increasing; demand may not keep pace. Who are the leading demanders of US debt? According to data provided by the Treasury Department, China is largest foreign holder of US Treasury notes, followed by Japan. The United Kindgom and the major oil exporting nations are other leading buyers. China's position has held over the last year. As foreign holdings have grown my roughly 20 percent, China's holdings have grown in kind.

But there are indications that the supportive balance between US debt issuance and Chinese purchases is teetering. Politics may matter just as much as economics in maintaining the stability of this relationship. In this regard, the United States is in a relatively weaker position now than in the past. Chinese premier Wen Jiabao has warned in recent weeks of the potential for a double dip in the global economy. In his once-yearly press conference - which follows the adjournment of the National People's Congress - the premier was stalwart in his defense of China's exchange-rate policy. He was also sharply critical of American policy towards China and Western pressure to revalue the yuan, assuming a tone that underlined his sense of China's growing global prominence. Speaking from Beijing following two intensive weeks of policy meetings, Mr. Wen cited concerns about domestic inflationary pressures, instability in heavily indebted Western economies, and the middling pace of employment recovery in the West as among China's primary concerns. On the issue of exchange rates, Mr. Wen ceded no ground, stating that "a country's exchange-rate policy and its exchange rates should be decided by its national economic situation." He further clarified that "I do not think the renminbi is undervalued." In an apparent retort to Mr. Obama's call for exchange-rate flexibility, Mr. Wen offered the following: "We are opposed to countries pointing fingers at each other or taking strong measures to force other countries to appreciate their currencies. To do this is not beneficial to reform of the renminbi exchange-rate regime." Sunday's comments by Mr. Wen suggest that American views on this issue hold little sway and that we should not expect that exports will benefit from a rising yuan. The bounds of American influence over Chinese policy were apparent when he implied that the administration's exchange-rate position "is a kind of trade protectionism." Inevitably, charges of protectionism depend critically upon one's perspective. In February, a bipartisan group of 15 senators sent a letter to Commerce Secretary Gary Locke alleging that "China's actions with respect to its currency constitute a countervailable subsidy." According to the Commerce Department, these subsidies may be offset by higher import duties on products from the offending country. New York's senior senator, Chuck Schumer, has taken a clear position, stating that "the bedrock of our economic system is fairness, and China's currency practices violate that principle in every single way." For his part, Senator Graham stated that he is "convinced that the Chinese government manipulates its currency in a manner that creates an unfair advantage for Chinese companies competing with the United States and the rest of the world." While characterizations of the Chinese position in the American media may suggest a combative approach to economic and trade policy, China is far from isolationist. Mr. Wen seems keenly aware of the interdependence of the world's major economies and China's role in an integrated system of global trade. He has been careful to point out that "without a recovering world economy, China's recovery cannot [be] sustain[ed]." Apart from recognizing China's dependence on foreign demand for its goods, Mr. Wen seeks to position himself as a strong proponent of free trade in general. This should come as no surprise given that China surpassed Germany in 2009 to become the world's largest exporter. In the decade leading up to the global recession, China's exports grew by almost 25 percent a year, allowing it to surpass the United States, Germany, and Japan in its share of global exports. A productive relationship with China is absolutely necessary for America's prosperity, and vice versa. While the United States is China's largest export market, China remains the United States' largest creditor. Strong Chinese demand for Treasuries is a cornerstone of budget assumptions in the United States; the Treasury Department reported that the budget deficit widened to a record $221 billion in February. Few mainstream economists believe that the United States will default on its debt obligations. Concerns relate principally to supply and demand and the interest rate environment rather than the possibility of an outright default. The Financial Times quotes Pierre Cailleteau, head of Moody's sovereign ratings, as saying that "the size of debt makes the U.S. vulnerable to an interest rate shock." Those sentiments have been echoed by Mr. Wen, who expressed concerns about Chinese investments in American debt. He went on record about those concerns at his press conference in 2009 and raised them again this year. "We have lent a huge amount of money to the U.S.," he said last year. "Of course, we are concerned about the safety of our assets." Commercial real estate lenders and borrowers alike can attest that relationship lending matters. When lenders weary of their borrowers' spending practices, that relationship may sour.