The Bond Vigilantes blog caught my eye this morning, with an excellent post and chart which inspired this version above. What this chart shows is that (up until last summer, that is) bond yields have been strongly influenced by the market's understanding of how weak or strong the economy. The white line is the Citi Economic Surprise Index, which tracks how actual economic news releases compare to expectations. The index has moved up strongly since last summer, as almost every economic indicator has come in stronger than expected (with the weekly claims report this morning the latest example). In the past, a stronger-than-expected economy such as we've seen in recent months would have led to a substantial rise in Treasury yields (10-yr yields are shown in orange). But not now, most likely because (and here I agree with the Bond Vigilantes) the market is terrified of PIIGS defaults. The news in the U.S. has clearly gotten better, but the news coming out of the Eurozone has been pretty awful, and Treasuries end up being the beneficiary of the world's intense demand for safe-haven assets.
The Fed and others might argue that Operation Twist (the Fed's current program of selling short maturity bonds and buying longer maturity bonds) is responsible for holding down 10-yr yields, but I don't buy that. The Fed can control the level of short- and intermediate-term yields, but not long-term yields. Thought experiment: if the news in Europe suddenly took a turn for the better (e.g., PIIGS governments took genuine steps to curtail spending), wouldn't you expect 10-yr yields to rocket higher?
The bond market is likely a tightly coiled spring, with yields compressed by fears of Eurozone defaults and a possible collapse of the Eurozone financial system. 2-yr Eurozone swap spreads confirm this, as they are still trading at nosebleed levels of 115 bps. To push yields down further would require these fears to be realized by a succession of truly awful events (and that's where I disagree with the Bond Vigilantes).
Think about yields in Japan.
ReplyDeleteBond investors may be thinking that equities and real estate markets are in mild secular deflation mode. That would make bonds attractive.
Stocks and property are down 80 percent in Japan in last 20 years, while the bank of Japan crushed inflation several times over. Are we on same path? If so, then buy bonds.
There is also a glut of global capital, seeking secure home. That secular problem will keep bond yields down for a long time.
I expect bond yields to go even lower, as I did a year ago (and I was right).
If the Fed wants to cure this malaise, they will have to set up growth and inflationary expectations. So far, they have convinced the market they will not tolerate inflation. ECB too.
I am optimistic, but I would be a lot more optimistic if Bernanke would read his literature regarding Japan--a nation where industrial output has fallen by 20 percent since 1995, according to Mark Perry.
Yields ignored in countries that can print their own money...Japan, US, UK, etc etc.
ReplyDeleteRead an interesting article yesterday on this one. The bond vigilantes are powerless against the Fed and Treasury + Printing Press.
I've been short UST but am starting to think this is the wrong way around.
"Where the bond vigilante story is usually flawed is in thinking that the bond vigilantes have power. Shorting government bonds when the central bank is politically aligned with the Treasury is a sure-fire way to lose lots of money. The consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities. Why would anyone think they can win that game?"
http://www.nakedcapitalism.com/2011/12/wray-on-krugman-and-currency-sovereignty.html
Thank you, Scott. That is a very interesting chart!
ReplyDeleteScott, you forgot to mention the Chicago Fed National Activity Index that was reported at the same time as jobless claims as well as GDP which also reported at the same time.
ReplyDeleteWhy are these two so poor when all the other indicators are up?
Squire: I don't pay much attention to the regional Fed surveys. I've never found them to be very useful.
ReplyDeleteThe Chicago Fed National Activity Index is not a regional survey. Hence the word "National."
ReplyDeleteThat said, the CFNAI has nothing to do with the bond market which, after all, is the topic of this article. Don't know if the Citi Economic Surprise Index includes the CFNAI or not.
Scott,
ReplyDeleteI want to wish you and your family a joyous holiday season and a very happy new year. And I want to express my appreciation for your blog. You are so insightful, unrattled, concise, sensible, intelligent,credible and right that you shine like a beacon of light through the fog of pundits/talking heads who speak well but say nothing of any real value. I look forward to your writings in 2012. It will be a special year with the coming election and further indication on the EU and ramifications.
Kenneth
It's interesting the the financial fault lines roughly follow the boundaries of post Reformation Europe. Portugal, Ireland, Italy, Greece, and Spain (PIIGS) are predominantly Catholic. The Nordic countries, Germany, and UK - all in much better fiscal shape - are predominantly Protestant.
ReplyDeleteJohn said...
ReplyDelete"It's interesting the the financial fault lines roughly follow the boundaries of post Reformation Europe."
A visiting French college student once expounded upon a religious / economic theory for the differences between northern and southern Europe. Basically the Reformation empowered individuals to read and think for themselves - not just about the Bible but the whole universe.
The Enlightenment with its emphasis on humanism - the individual - and his ability to understand the world through reason and experimentation followed. This resulted in a more individualist society in the Protestant North.
Catholicism and paternalism lead to a different economic society in the South of Europe. The so-called Protestant Work Ethic didn't take root in the South early on. This lead to crony capitalism, strong hereditary guilds / labor unions and, until this day, the diminished position of women.
John and William-
ReplyDeleteIt the Mediterranean blood, or Latinate culture.
The warmer and more friendly people are, the worse their governments and budgets are.
You want to import Nordic administrators to Italy and then live there.
I think you'll find that the churches in Europe both north and south are empty. I can't imagine that whether you are Catholic or Protestant has anything to do with economic productivity these days. Ireland and Spain were booming in the early 2000s because housing lead the way. They are crashing now because housing crashed.
ReplyDeleteScott-
ReplyDeleteI would like to reiterate Kenneth's sentiments, your blog has become an indispensable resource as well as a joy to read. Happy Holidays to you and your family.
On to business. You've got me following the various Euro yield curves intently. I notice that Spain is doing well both at the short and long ends of their curve while Italy is doing slightly better on the short end but not so well on the long end. My thesis is that this comes from the Spanish electorate having voted to take their medicine recently by installing Rajoy, so structural reform is more believable. In contrast Italy has had an elitist technocrat - steeped in Euro-Keynesian fatal conceits - installed undemocratically and technocratic tinkering is likely to win out over true structural reform (at least for now). For me, this means that the Euro crisis is still simmering, but the locus remains Italy. Your thoughts?
Donny: I agree. The Eurozone crisis is still alive and well. It won't be fixed until a) there are defaults/restructurings, and/or the PIIGS countries take real steps to shrink the size of government. Tax hikes are not the answer, since that weakens the private sector and allows the public sector to grow, and that is the worst outcome.
ReplyDeleteThe Dallas Fed is reporting PCE deflation in October and November, by 0.7 percent and 0.5 percent.
ReplyDeleteBond yields are high when you consider this.
Scott,
ReplyDeleteI echo Kenneth and Donny. Wishing you and yours a Merry Christmas and a Happy and Prosperous New Year.
I look forward to reading your blog regularly in the coming year.
Many thanks to all for the kind comments. I sure hope next year brings more cheer, but we mustn't forget that things are a whole lot better than they were supposed to be a few years ago.
ReplyDeleteMerry Christmas and thanks for a great year of calm, thoughtful guidance through the turbulent markets. Let's hope you can put your calm Calafia beach picture back up on your blog in 2012!
ReplyDeleteI wish to extend a Happy Christmas to the readers and the rest of the posters...
ReplyDeleteGlory to Jesus!
A belated Merry Christmas to all. Just wanted to say thanks to Scott for all the effort he puts into this blog I've made it my primary resource in formulating my own financial opinions. But what makes this sight so special are the regular bloggers who comment here, it seems Scott attracts the best and brightest.
ReplyDeleteScott-
ReplyDeleteYou've mentioned TBT here several times. I am long TBT (or short treasuries) as well based on a belief in a coming bout of inflation, an improving economy and a deteriorating US fiscal outlook. All good reasons, and all perfectly irrelevant as treasuries have soared and holding TBT has been a disaster of late. Still, I am sticking with this as IMHO the Euro crisis has intervened to forestall the eventual vindication of the listed bearish fundamentals for US debt. Also, I now see TBT as a hedge against Obama's re-election. If he wins a second term, there is no reason to expect a cessation of the @ $1.3 trillion deficits in years 5-8. I don't think the US can absorb another $5T+ of deficits and, despite all the poo-poohing of the "Bond Market Vigilantes", I think the bond market will react violently at the prospect. This is essentially Cochrane's thesis.
Do you agree with this?
Donny: you make some good points. But it's tricky trying to guess what could make bond yields rise. To date bond yields have been kept at extremely low levels due to a) a very weak recovery, b) extreme concern over the fate of the Eurozone, and c) an absence of any big increase in inflation. Japanese bond yields have managed to remain extremely low for years despite deficits which, relative to the size of Japan's economy, are much larger than Obama's, mainly due to a lack of inflation and Japanese savers' belief that default and/or devaluation are highly unlikely. This would argue in favor of bond yields remaining low in the U.S. as long as inflation does not pick up meaningfully.
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