Friday, September 18, 2009

Why the bond market is so complacent

This issue—why T-bond yields are so low with gold over $1000 and the dollar falling and commodities rising—seems to be a hot topic, so I thought it worthwhile to repeat and clarify my views. I had a post on the subject last week, but here is another shot at making things more concise:


From a supply-side perspective, gold at $1000/oz. is clearly indicating rising inflation pressures. So is the rise in most commodity prices, and the weakness of the dollar. All suggest the Fed is oversupplying dollars to the world and that will eventually show up as higher inflation.

Meanwhile, equities are rising, suggesting the economy is recovering.

Why is the bond market so complacent, with 10-year Treasury yields at 3.5%, in the face of these facts?

Answers:
1) The bond market has never been very smart about inflation, and neither has the Fed. Everyone underestimated inflation throughout most of the 1970s, and everyone overestimated inflation throughout the 1980s and 1990s. 

2) All the internals of the bond market are consistent with the view that inflation is not a problem. TIPS spreads today say inflation will be 2-2.5% for the foreseeable future. Short-term rates say the Fed will keep rates at close to zero for a long time. 10-yr yields are very low from an historical perspective, consistent with the economy remaining weak and inflation remaining low.

3) The widespread belief in the Phillips Curve theory of inflation (which says that economic weakness leads to falling prices) explains why the bond market and the Fed are complacent: the economy is perceived to be so weak that inflation is almost impossible. 

4) Although stocks are way up and credit spreads are way down, that is not necessarily an indication of a strong economy or a recovery. Credit spreads are still wider today than at the peak of the 2002 credit wipeout. Equity prices have only recovered to levels first seen over 10 years ago, despite the fact that corporate profits (according to the NIPA data) are much higher. So credit spreads and equity prices are consistent with a view that the economy is going to be very weak and a double-dip recession is a real threat. The improvement in spreads and equity prices is due mostly to the fact that the economy appears to have avoided a catastrophic depression/deflation.

5) The 2-10 spread is about as wide as it gets. That shows the bond market is not completely stupid, since lots of Fed tightening is priced in over the next 10 years. But with the Fed insisting that they will keep rates at zero for a very long time, the curve is about as steep as it can get for now.

6) You don't need to rely on Fed purchases of Treasuries and MBS to account for the apparent complacency in the bond market. (In other words, Fed purchases have not kept interest rates artificially low by any meaningful amount.) All of the observations above seem internally consistent. There is no sign of mispricing in the bond market. MBS spreads are perfectly average. Credit spreads are still very wide, suggesting a very weak economy. A very weak economy supports the Phillips Curve belief that inflation is almost impossible, supporting the low level of bond yields.

7) So the Fed is really the key. If the Fed is not concerned about inflation (and they aren't because of the Phillips Curve), then the bond market isn't.

But that doesn't make the bond market right.

22 comments:

Jake said...

thoughts on the possibility that treasuries (like all assets) are being bid up by the liquidity sloshing around (i.e. demand).

that would explain why there are bids for equities, commodities, credit (corporates, muni's, abs, mbs), and treasuries all at the same time.

as long as there is a buyer that will take the treasuries off of you at a higher price, there is no fear that rates will eventually go up (the same thought process as to why housing prices rose).

BUT, like the housing market either the treasury market or equity market has it completely wrong, fundamentals will eventually win, and asset prices of one or the other (or both) will reverse course in dramatic fashion.

it will be interesting to see if you are correct that it is treasuries that are incorrectly priced at the moment...

seekingtraceevidence said...

I think you under estimate the effect of the carry trade. With a little leverage say 10:1 buying 3.4% 10Yr Treasury using 0.1% funding cost gives the HFs a very nice return of over 30%. This expanation works for rising gold, oil, copper, EmgMkts, SP500 and 10yr Bonds when the Treasury has issued some $2Tril+ in securities. Oh yes. The Fed has been buying as well, but only to about $1Tril

Scott Grannis said...

On the contrary, I think the carry trade explains a lot of things. To begin with, you wouldn't want to put on a huge carry trade if you didn't believe the Fed would keep rates low for a long time. The Fed's promise to keep rates low is what keeps the yield curve from steepening further. People, HFs, whatever, all have an incentive to buy risky assets.

But should the perception of low rates forever change, then the dynamics can also change rapidly and hugely.

Regardless, I've argued before that Fed purchases have not resulted in an artificial lowering of interest rates. They just aren't big enough. If the Fed were distorting things, you should see it in rising breakeven spreads, but that's not happening.

Scott Grannis said...

Jake: "all the liquidity sloshing around" is part of the "easy money" and "oversupply of dollars" that is pushing up the prices of risky assets and commodities and gold. It's just another way of talking about the impact of Fed policy.

kfunck1 said...

"Consider too, that the Fed gobbled up its $866 billion or so in just 8 months, consuming more than half the new supply of GSE securities. When prepayments are taken into account (outstanding security balances shrink as new securities are made), at many points over the last year the Fed has inhaled over 100% of net supply. This is in effect a massive market technical that squeezed mortgage spreads to historical tights. At many points too tight for value oriented long term investors (institutional investors and the GSEs) to want to buy them."

http://www.housingwire.com/2009/09/17/viewpoint-the-wrong-way-to-think-about-the-fate-of-the-gses/

Am I misunderstanding something here? That sounds like a pretty big impact.

Scott Grannis said...

I think what you are missing here is that bonds are fungible. Adding a new 10-year bond to outstanding supply of bonds cannot affect the price of all bonds. For if the new bond is to have a higher interest rate, then the yield on all bonds must have a higher yield as well, and the price of all bonds must fall. So even if the new bonds are only a fraction of the value of the existing bonds, to reprice the new bonds you must reprice all bonds. And that is where it doesn't make sense. The new flows of bonds is a fraction of the value of the existing stock of bonds. So the major determinant of the price of the outstanding stock is the demand for bonds in general, not the price that is required to sell the new bonds.

I think I'm going to have to do a post on this to make it clearer. Maybe some time this weekend.

Brian said...

I'm confused about the rise in gold vs. the slow economy making inflation nearly impossible. Is it a result of different schools of thought making their separate bets, or is the inflation just dialed in and a long way off?

Scott Grannis said...

You need to read my posts that explain the Phillips Curve theory of inflation. I should have referenced them in the text of this post. It's quite controversial, since many economists, myself and Fed economists included, argue that there is no evidence to support the theory, yet it remains hugely popular.

As a supply-sider I believe that inflation has nothing to do with the strength or weakness of the economy. It is purely a monetary phenomenon. It happens when the supply of money exceeds the demand for money. You can see evidence of that occurring by watching sensitive prices such as the value of the dollar, gold, commodities, the shape of the yield curve, and real interest rates.

Brian said...

Got it. Thank you!

Charles said...

People obviously believe that it will be easy to dump bonds at the first hint of higher interest rates. If I believed the fed's stated intentions and if I believed that they could be carried out, then I would go long on everything except T-bills.

Mark A. Sadowski said...

Scott,
You wrote:
"It's quite controversial, since many economists, myself and Fed economists included, argue that there is no evidence to support the theory, yet it remains hugely popular."

Among credentialed economists it's not at all as controversial as you imply. In fact with the exception of a few RBC/Neo-Classical economists it's the starting point of any discussion of current monetary policy.

Here's my short history of how it has evolved. Back in 1958 Keynesian economist William Phillips theorized that there was a permanent tradeoff between inflation and unemployment that could be exploited by policy makers. The relationship was of course inverse and policy makes could simply shoose whatever combination of inflation and unemployment rates they thought was desirable.

But then inflation started to increase for any given unemployment rate in the mid to late 1960s (which gave rise to the term "stagflation") and it became evident that there was no permanent trade off. This gave rise to the "accelerationist hypothesis" by monetarists Milton Friedman and Edmund Phelps, which essentially stated that any attempt to hold the unemployment rate below the "natural rate" would lead to accelerating inflation. They advocated a nonactivist approach to monetary policy believing that the unemployment rate would tend towards the natural rate without any intervention.

Then in 1975 Franco Modigliani and Lucas Papademos coined the term noninflationary rate of unemployment (NIRU) which was later revised to nonaccelerating rate of inflation unemployment rate (NAIRU). While Friedman and Phelps believed that the existence of a natural rate implied that there was no useful trade-off between inflation and unemployment, Modigliani and Papademos interpreted the NAIRU as a constraint on the ability of policymakers to exploit a trade-off that remained both available and helpful in the short run.

But despite the fundamental differences that still existed between the monetarists and the Keynesians, the NAIRU was seen by many contemporary economists as helping build a consensus about the nature of the inflation-unemployment relationship.

At first there was an attempt to estimate a fixed NAIRU for the United States that was valid for all time periods (usually estimated to be between 5.5% and 6.0%). By the late 1990s, as unemployment dropped well below that rate and yet inflation continued to be moderate, this idea was questioned. Now it is fairly well accepted that NAIRU varies over time. The CBO maintains a NAIRU data series that ranges from a high of 6.2% in the mid 1970s to a low of 4.8% since 2001.

Well, in any case inflation seemed to behave according to the "accelerationist" Phillips Curve from the 1970s through the early 1990s. In fact the decline in inflation during the early 1980s was generally credited to the tight money and high unemployment rates and large output gaps that the US experienced at that time (inflation could also "de-accelerate" of course).

Since at least the mid 1990s however inflation has demonstrated a great deal more persistance. In other words core inflation seems to be staying close to about 2% with a slight deviation depending on the size and direction of the output gap. This has given rise to the Phillips Curve's third iteration known as the "expectations augmented" Phillips Curve. If expectations are "well anchored" then inflation tends to be persistent. If expectations are "unanchored" then inflation will behave as according to the accelerationist Phillips Curve.

This latest version is informed by rational expectations theory and holds that as long as the central bank is viewed as credibly committed to an inflation target then inflation will tend towards that perceived target.

A good article on the current thinking on inflation (and our current risk of deflation, or more properly, lack of risk) is by John Williams of the FRBSF and is available here:

http://www.frbsf.org/publications
/economics/letter/2009
/el2009-12.html

Mark A. Sadowski said...

P.S. I liked your discussion of the current bond market situation. It was very clear and even handed. However I believe that bonds will be proven correct eventually.

Blake Huber said...

hi Scott -- thank you for another excellent post on the bond market.

I have been hearing more and more often that since early 80's gold pricing is no longer mainly correlated with inflation, but actual supply and demand in the metals market.

Would greatly appreciate your thoughts on this, as I'm (possibly naively) wondering if gold is simply rising bc other asset prices/ commodities are rising.

many thanks,
Blake

Public Library said...

I really feel you are completely underestimating the differing types of government intervention implemented so far.

This is not just about the quantity of TSY purchases. The entire US market has been subsidized or guaranteed in some way or another.

Look at the new Edmunds.com prediction for Sept. light vehicle sales (8.8MM units). This is worse than when we were at the depths of the recession in Q4 '09 (9.1MM units)

Cash for clunkers, as we all know, was terrible policy but the pain has only begun for autos. Many now predict CFC round two.

This is not much different from propping up banks or giving tax credits to unworthy home buyers. Once the Gov heads down this road it is not unreasonable to believe they will continue to throw good money after bad.

You are betting the current government policies will turn out rosy. I believe otherwise.

The government is too involved in engineering the current market rally fueled with bad policies and implicit guarantees as far as the eye can see.

Good luck extracting it when the market wobbles sideways or even worse, turns down.

If expectations theory is applied, then the market does not need the Fed to purchase tons of securities so long as they believe they will continue to do what is necessary to prop up the markets.

However, this will not end pretty. The Japanese markets rallied 20-40% many times over the last two decades yet the Nikkei is off 74% from its highs.

We are no different though we like to think we are. Politics and policy will play a major role in determining the next decade.

The beginning does not give me great comfort.

Scott Grannis said...

Blake: you might want to check out the new edition of one of the classic books on how gold holds its value over long periods.

"The Golden Constant" by Roy Jastram.

Info here:

http://www.gold.org/assets/file/pr_archive/pdf/golden_constant_260809_pr.pdf

Interesting factoid: I first learned of this book in the early 1980s, since Roy Jastram happened to be the father of my secretary.

The book has been updated to include an analysis of the behavior of gold from the 70s through 2007. I don't think it's main conclusions have changed.

Scott Grannis said...

Blake: Further on gold. The price of gold is determined by the world's demand to hold that outstanding stock of gold, which is well over 100,000 tons. Annual production and demand for gold (for jewelry, etc.) are very small relative to the stock of gold, about 3%. There are lots of facts about gold at the World Gold Council website: gold.org

Scott Grannis said...

Public: I have never said that government policies are great. In fact I have said repeatedly that government policies are acting as a headwind to the economy's recovery. The economy is recovering in spite of all the mess that is coming out of Washington. This economy is so big and so inherently dynamic that it doesn't require hand-holding from the government. yes, better policies would yield a much more robust recovery. But in the meantime the economy has gone through a lot of adjustment on its own, and thus the recovery is for the most part genuine.

I think you are letting your disdain for the current administration cloud your judgment.

Blake Huber said...

Thank you! I'll check out the link.

Best,
Blake

Public Library said...

I really have no opinion about the current administration. It is too early to tell.

My comments are in reference to broader government intervention which eventually results in asset bubbles and or dislocations in markets.

The current confluence of activity from all government agencies leads me to believe another catastrophe is in the making.

It needn't be this year or next. But current policy prescriptions by the Treasury, Fed, and Congress are no different, and arguably worse, than the prevailing 15 years.

That worked out real well for us.

Our leaders have bolstered and expanded bad policy behavior to unprecedented levels.

This is more an accumulation of misguided beliefs across administrations and government agencies than anything else.

Nothing has changed except the ante was raised.

Scott Grannis said...

I won't argue with you about the extent of misguided policies and policies that are downright harmful to the economy. We're likely to run into trouble as a result of all this, but it might not happen for many years. Meanwhile I think the natural recovery forces are dominant. Plus, I see important changes in the mood of the electorate which suggest that the destructive tendency in policy may be mitigated or even partially reversed in coming years.

Public Library said...

Maybe you are right about Congress, but I am more fearful of the Fed than anything else...

Taylor Frigon Capital Management said...

Hi Scott -- helpful post. We linked to it in today's edition of the Taylor Frigon Advisor at
http://taylorfrigon.blogspot.com/2009/09/who-are-you-going-to-believe-gold.html

Hope you approve of the sentiments there --

best regards,

TFCM