Thursday, August 26, 2010
Like many others, I remain fascinated by the rally in bonds that has taken the 10-yr yield to 2.5%, only 50 bps above its all-time lows which first occurred when the economy was mired in a decade-long depression and deflation. Is that the fate—depression and deflation—that awaits us today? How can we have ultra-low yields at a time when the federal deficit is gigantic and federal debt/GDP ratios are soaring? I have some thoughts and speculations.
One explanation would be that the market is simply priced to the expectation of deflation. But that hypothesis is not validated by TIPS spreads, because inflation expectations are still reasonably positive: a 1.4% CPI on average over the next 5 years, and 1.6% over the next 10 years (see next chart). Deflation was our expected destination at the end of 2008—TIPS spreads were flat to negative, and TIPS yields soared because deflation fears were so strong that nobody had any interest in the securities. But things are very different today, with 10-yr TIPS real yields of 1% reflecting very strong demand for TIPS.
So perhaps the explanation behind ultra low yields is simply that growth expectations are extremely low; after all, we know that the market has been obsessed with a double-dip recession for awhile, so perhaps a real doozy of a recession is being priced into 10-yr Treasuries—something like a depression but without the attendant deflation that we saw in the 1930s.
But that hypothesis is not convincingly validated by the corporate bond market, where spreads are trading at levels that are similar to or less than what we saw in advance of the (very mild) 2001 recession, and at levels that are an order of magnitude less than what we saw at the end of 2008, when a depression was indeed priced in.
So perhaps there is, in addition to weak growth expectations, an inordinate fear of the future: a fear of big tax hikes, and of a prolonged economic malaise caused by an overbearing state that absorbs the fruits of and smothers the private sector. Japan comes to mind, with its massive deficits, a debt/GDP ratio that has been well into triple digits for years, and sluggish growth. Perhaps it's the case that as debt approaches and exceeds 90% of GDP the economy simply loses much of its forward momentum, a thesis supported by the findings of a recent research paper by Rogoff and Reinhart. There's even some support for this thesis in our own history—muddled of course, by WWII—when federal debt surged to 120% of GDP in the early 1940s, even as 10-yr yields traded at 2% or so.
This last explanation appears to be the most satisfying, given the various signals available in our capital markets. Animal spirits are seriously lacking, thanks to a massive expansion in the size and role of the government, coupled with the host of uncertainties which surround the future course of monetary policy—for example, many observers argue today that the Fed has run out of ammunition to jolt the economy out of its (supposedly) current funk. If the market is scrambling to buy bonds yielding 2.5% or less, it only makes sense if market participants hold little or no hope for a better alternative in the foreseeable future on a risk-adjusted basis.
It also makes sense that today's almost-zero yields on cash, extremely low yields on risk-free bonds, and massive debt sales become in a sense a self-fulfilling prophecy. Low yields represent very low hopes and aspirations on the part of the private sector, while the bonds being sold and the money absorbed from the private sector by our federal deficit are being used to fund a level of spending and wealth redistribution such as we have never seen before. For those of us who believe the spending multiplier is much less than one, it makes perfect sense that a huge increase in spending can only result in a dismal return on investment—i.e., a moribund economy. Ultra-low yields on Treasuries thus reflect dismal growth expectations while at the same time virtually ensuring that growth will be disappointing.
We're not witnessing a bond bubble in the making, we're living in a statist nightmare. Bonds are not in a bubble, because they are priced rationally if you believe, as the market seems to, that the outlook for the future is grim.
The future, however, is not written in stone, and there is little reason—in my view—to expect that the current state of affairs is going to go on forever. But you have to be an optimist to venture outside the safe haven of ultra-low Treasury yields that only the pessimists are content to receive. Today's bond market will prove to be a bubble if and when the people take back control of government from the statists currently occupying the White House and running Congress. I believe they will, come November. If you don't, then go out and buy some of those Treasury bonds; you'll have plenty of company.
Posted by Scott Grannis at 5:49 PM