Recent market events challenge some traditional economic theory. When the Fed keeps interest rates low, that isn’t supposed to cause real long-term rates to rise. But it often does. The reason appears to be that investors need to seek higher yields to compensate for the low rates engineered by the Fed. Here’s a speech to economists explaining the theory, and giving a pretty clear explanation of how it works. It might be too academic for some, but for most iti s worth reading through.
The theory we sketch involves a set of “yield-oriented” investors. We assume that these investors allocate theirportfolios between short- and long-term Treasury bonds and,in doing so, put some weight not just on expected holding-period returns, but also oncurrent income. This preference for current yield could bedue to agency or accountingconsiderations that lead these investorsto care about short-term measures of reportedperformance. A reduction in short-term nominal rates leadsthem to rebalance their portfolios toward longer-term bonds in an effort to keep their overall yield from declining too much.This, in turn,creates buying pressure that raises the price of the long-termbonds and hence lowers long-term yields and forward rates.