The yield on the 10-year bond, which has trailed GDP growth, is expected to rise only slightly in 2018 as market forces cap rates.

The difference between 10-year Treasury yields and U.S. growth is unusually wide. Nominal GDP growth averaged about 4% over the past few years, while the nominal yield on the 10-year note was 2.4% at year-end 2017. So, why are yields so far below the growth rate?

Ten-year yields can be understood in many ways. In a stable, closed economy with inflation holding at the central bank’s target, it’s easy to derive the result that the 10-year yield should be close to the growth rate of the economy. After all, there is a relationship between the policy rate (the fed funds interest rate) and economic growth. This relationship is not as close as textbooks suggest since the policy rate is a risk-free rate, and growth should compensate for risky capital. But there clearly should be some relationship.

The question is whether a world where monetary policy is gently tightening and short-term rates are rising is also a world where 10-year yields move closer to nominal growth rates. Do “normal” monetary policy and “normal” two-year yields mean we should see “normal” 10-year yields? We continue to think the answer is no. The “stable, closed economy” model simply isn’t working. Capital flows are too large for the “closed” piece of the model to apply, and there are too many long-term forces at work for the “stable” piece of the model to apply.

Do “normal” monetary policy and “normal” two-year yields mean we should see “normal” 10-year yields?

Instead, it makes sense to think of yields like any other price: It’s a result of supply and demand. Last month, we wrote about the yield curve, and we received a number of questions. So, let’s briefly consider the factors currently driving supply and demand, and how they may change in 2018.

Demand for Treasuries remains strong. A legacy of the 1998 financial crisis that swept across emerging markets is that global central banks’ demand for reserves has shifted significantly higher. As a result, foreign central banks hold about two thirds of their reserves in Treasuries.

Monetary policies in the G10 and Japan also play a role. The Fed is tightening policy, but the European Central Bank (ECB) and the Bank of Japan (BoJ) continue with quantitative easing (QE). These bond-buying programs have anchored yields on the long end of the bond market. While the Fed’s quantitative tightening is having an impact on the front end of the U.S. yield curve, it clearly hasn’t done much, if anything, for the 10-year note.

Japan’s policy is particularly important because unlike other QE programs, which pass specific quantities of money to the private sector, the BoJ’s policy cares about quantities only insofar as they produce price effects. The BoJ targets the 10-year Japanese government bond yield and carries out enough QE to ensure this target is met. There’s clearly a limit to how far U.S. yields can rise when Japanese yields are capped.

Instead, it makes sense to think of yields like any other price: It’s a result of supply and demand.

There’s a chance all this will change later in 2018. The ECB may end its QE program in September, and the BoJ may reconsider its dovish policy. That could change the supply/demand balance in the market, pushing 10-year U.S. yields higher.

Private demand for low-risk government debt remains strong. Regulatory changes affecting financial institutions have given them strong incentives to hold government securities. You need to only look at the eurozone and the Italian banking system to understand this.

On the other hand, corporate sector demand for investable funds is low. This may reflect changing technology, reduced capital investment, and a decline in the relative price of capital goods. Looking ahead, rising business confidence and lower U.S. corporate taxes could boost investment, and thus an increase in demand for investable funds.

Reluctance to increase supply

It’s important to note that governments are reluctant to increase debt supply. Concerns about debt levels and debt dynamics after the financial crisis made fiscal expansion politically unpalatable. The Europeans have enshrined austerity in the founding documents of the eurozone.

Private-sector supply of debt is also changing due to demographics. The post-Lehman financial crisis and the collapse of housing prices made a lot of households very nervous about their balance sheets. As a result, household savings rates have risen. Income inequality, changing age distribution in the population, and higher life expectancy will affect aggregate savings rates. Funding longer retirements, and perhaps a motive to provide bequests to the next generation, may be lifting savings rates of older cohorts, increasing household debt supply.

Aside from supply and demand, inflation risk could also influence yields. Could fears of a resurgence in inflation push nominal yields a lot higher? We think the risks of a general inflationary upsurge is low because of the institutional and structural features of the world economy.

Return to normal?

Ultimately, we expect 10-year bond yields to rise only a little in 2018. Some of the factors mentioned above will change in 2018, and there is some upward risk to rates. But others will remain in place and keep the gap between nominal GDP growth rates and nominal yields much wider than a “return to normal’’ would suggest.

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The outlook for U.S. and global growth remains solid in 2018. However, the relationship between the improving U.S. economy, the Fed funds rate, and the benchmark 10-year Treasury yield is somewhat of an enigma.