One of the great finance puzzles of the past decade is why long-term interest rates are staying so stubbornly high. Even as short-term rates have plunged to a 29-year low, long-term Treasury bond yields have barely budged. Indeed, they are still above their 1986 lows, and bond rates have been heading up in recent days. Many economists blame the federal government's $350 billion budget deficit for keeping long-term rates in the stratosphere. Others point to investors, badly burned by underestimating inflation in the late 1960s and 1970s, who are unwilling to gamble that the inflation dragon is slain despite little evidence of upward price pressure.
Another important, but often neglected, reason is the Japanese sell-off of U.S. debt securities, says William P. Sterling, an economist at Merrill Lynch & Co. Japanese investors have been unloading their holdings in an effort to prop up their ailing financial system as the Tokyo stock market has tumbled. According to Treasury Dept. data, Japanese holdings of U.S. Treasury securities fell from $102 billion at the beginning of 1989 to $72 billion by the first quarter of this year.
Just as huge inflows of Japanese capital during most of the 1980s depressed interest rates on U.S. Treasuries and supported America's economic boom, says Sterling, the recent outflow of Japanese investment is keeping U.S. bond yields high and hampering the U.S. economy's rebound. He estimates that long-term interest rates would be about half a percentage point lower were it not for the Japanese selling. If Sterling is right, the continued weak performance of the Japanese stock market and the enormous U.S. budget deficit add up to high long-term interest rates for a long time to come.