The Contribution of Foreign Holdings of U.S. Treasury Securities to the U.S. Long-Term Interest Rate

49 Pages Posted: 30 Dec 2019 Last revised: 2 Feb 2020

See all articles by Yixiang Zhang

Yixiang Zhang

affiliation not provided to SSRN

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Date Written: January 3, 2020

Abstract

We find empirical evidence of a possible structural break in the relationship between the foreign holdings of U.S. Treasury securities and the U.S. long-term interest rate occurring at the time when U.S. monetary policy became constrained at the zero-lower bound (ZLB). The estimated marginal effect of the foreign holdings ratio on the U.S. long-term interest rate, particularly its long-run effect, appears to have become stronger during the ZLB regime than it was before. We argue that the leading explanation of this apparent break is the nonlinearity introduced by the ZLB. Motivated by theory, we propose a flexible nonlinear specification to deal with the ZLB — a threshold single-equation error-correction model splitting the sample in two regimes, pre-ZLB and ZLB, which replaces the observed Fed Funds rate with a shadow Fed Funds rate derived from a Tobit-IV model to incorporate a broader measure of the stance of monetary policy. With this setup, we find no significant structural break in the relationship between foreign holdings and long-term rates at the ZLB. Therefore, we argue that the ZLB is a leading cause of the apparent shift in the empirical relationship. We also show that the estimated effects are not just statistically-significant, but also economically-significant. Through counterfactual analysis, we show that changes in China’s holdings of U.S. Treasury securities played an important role in explaining the 2004-2006 interest rate conundrum period and kept the long-term interest rate from going ever lower in the recent ZLB period.

Keywords: Long-Term Interest Rates, Foreign Holdings of Notes and Bonds, Expectations Hypothesis, Structural Break, Zero Lower Bound, Monetary Policy, China

JEL Classification: C24, E43, E58, F21

Suggested Citation

Zhang, Yixiang and Martinez-Garcia, Enrique, The Contribution of Foreign Holdings of U.S. Treasury Securities to the U.S. Long-Term Interest Rate (January 3, 2020). Available at SSRN: https://ssrn.com/abstract=3495790 or http://dx.doi.org/10.2139/ssrn.3495790

Yixiang Zhang

affiliation not provided to SSRN

Enrique Martinez-Garcia (Contact Author)

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

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