The Federal Reserve’s second-quarter flow of funds report, released on September 20, illustrated again some of the unique features of this business cycle—namely the unprecedented weakness in private-sector borrowing and the dominance of the Fed and foreigners in the Treasury market. While it is not unusual for federal borrowing to increase substantially during recessions, the size and duration of federal deficits in this cycle is exceptional. In addition, it is unprecedented in the post-World War II period for federal borrowing to be greater than private-sector borrowing. Even in the severe recessions of 1980–1982, federal borrowing accounted for only 35% of total borrowing in the U.S. capital markets. In the 1990–1991 recession, the federal government’s share of total borrowing reached almost 60%. In this cycle, that share was 135% in 2009, 110% in 2010, and 80% in 2011. During the first half of this year, federal borrowing accounted for almost 94% of total borrowing in the capital markets.

The collapse in private-sector borrowing is unprecedented
While the jump in federal deficits boosted those ratios, the collapse in private-sector borrowing was much more meaningful. Borrowing by households and businesses, which had been running at a rate of $2 trillion per year in 2006 and 2007, collapsed to a rate of $500 billion in 2009 and $200 billion in 2010—an unprecedented decline of more than $2 trillion per year. In 2011, private-sector borrowing recovered slightly to an annual rate of around $300 billion, and thus far in 2012, it is running at only a $500 billion annual rate. Borrowing in the mortgage market was running at a $1 trillion annual rate in 2005 and 2006, but, starting in early 2008, the volume of outstanding mortgage debt began shrinking—and that has continued through the first half of this year. At mid-year 2012, the volume of mortgage debt outstanding was $1 trillion, or approximately 10%, less than at mid-year 2008. For as long as the Fed has been collecting this data, there was never even one year prior to 2008 in which the amount of mortgage debt declined.

Weakness in private borrowing helps explain why bond yields have remained so low for so long. In previous cycles, the strength of private credit demands, not the pace of federal borrowing, has determined the direction of bond yields. When deficits were large, yields were typically at cycle lows because the economy was weak. When yields were rising, deficits were typically shrinking because the economy was strengthening. This would suggest that until private-sector borrowing—especially borrowing in the mortgage market—rebounds significantly, market yields could stay relatively low.

Finally, the heavy pace of Treasury borrowing has not pushed bond yields higher primarily because of record purchases by the Fed and strong demand from overseas. Over the past five years, those two groups have purchased almost 60% of the net increase in Treasury debt. Last year, the combined purchases of those two buyer groups accounted for 85% of the Treasury’s net issuance. In a typical year, Fed purchases of Treasuries accounted for a negligible share of the Treasury’s net sales. Last year, because of quantitative easing, that share was an astounding 60%. Thus far in 2012, Fed purchases have been minimal, as Operation Twist did not involve a net increase in Treasury purchases. Foreign investors, however, have remained active, with net purchases equal to 35% of the Treasury’s net issuance.

Why a cyclical rise in bond yields is, in our view, still not on the horizon
A long list of factors makes this cyclical recovery substantially different from that of previous cycles. In the financials sector, ongoing weakness in private-sector borrowing is a key difference. A flat housing sector accounts for much of this weakness because housing is a big user of borrowed money. Borrowing by business is also relatively soft, as companies have been spending cautiously and strengthening their balance sheets. Even the impact on bond yields of a record pace of Treasury borrowing has been blunted by strong demand from overseas and by quantitative easing by the Fed. Since none of these unusual developments are likely to change anytime soon, a cyclical rise in bond yields is, in our view, still not on the horizon.