Wednesday, January 16, 2013

Why Treasury yields are so low

December's Consumer Price Index was unchanged, as expected. It rose 1.74% last year, which, as the chart above shows, is somewhat less than its annualized rate of 2.4% over the past 10 years. Meanwhile, the core CPI rose 1.9% last year. It's hard to find anything out of the ordinary in the inflation stats these days.

What does stand out, however, is the unusually low level of T-bond yields relative to inflation. The chart above is structured to show that 30-yr bond yields over very long periods have averaged about 2.5% more than core inflation. If that long-term average condition were to prevail today, 30-yr T-bond yields would be trading around 4.5%; instead they are 3.0%. Bond yields were arguably fairly valued for much of the decade of the 2000's (as the two lines frequently overlapped). But in the past year or so, bond yields have fallen while inflation has risen, and 30-yr bond yields today are only slightly higher than the average inflation rate over the past decade. Thus, bonds arguably are richly valued today.

It's commonly thought that bond yields are low because the Fed is buying a lot of them in conjunction with its Quantitative Easing program. But the Fed todays owns only $1.7 trillion worth of Treasuries, or 14.4% of all the Treasuries held by the public. The public, in other words, owns $9.9 trillion of Treasuries, which is almost seven times more than the Fed owns. I find it hard to believe that the Fed's ownership of only a fraction of the outstanding Treasuries, and its willingness to buy another small piece over the course of this year, is enough to significantly distort the pricing of all of those securities. Common sense tells us that the price of Treasuries is determined by the public's willingness to hold the outstanding stock of Treasuries, not by anyone's willingness to purchase the new Treasuries sold on the margin.

What is more plausible is that the Fed's repeated promises to keep short-term interest rates low for an extended period, conditioned on the economy remaining relatively weak and with a surfeit of unused capacity, are convincing enough to encourage the market to bid up the price of Treasury notes and bonds beyond a level consistent with the prevailing inflation rate.

It's a readily observable fact that the economy has managed only a tepid recovery from its worst recession in modern memory, and it's clear that the burdens of government—spending, taxation, and regulatory—are greater today than they have ever been. It's not hard, therefore, to conclude that the economy is unlikely to grow by enough in the next few years to cause the Fed to accelerate its timetable for higher interest rates. This, I would argue, coupled with the market's generally high level of risk aversion (which can be found in $1700 gold, negative real yields on TIPS, the relatively low level of equity PEs, the 70% growth in bank savings deposits since late 2008, and the huge outflows from equity mutual funds in recent years), offers a much more robust explanation for why Treasury yields are so low today. The market is scared, and confidence in the economy's ability to generate stronger growth is very weak. The market is thus quite willing to pay a premium for the safety and security of Treasuries.

Low yields on Treasuries are thus an excellent indicator of how bearish the market is, regardless of what the surveys might say.


Gloeschi said...

OMG, Scott.

Only a paid Fed blogger would write something like this.

Jeff said...

How do you measure the impact of Fed buying on the margin? If 10 people all want to buy 10 available bottles of water, there is no price pressure. But add one more buyer and...

Scott Grannis said...

The marginal supply/demand balance for strawberries is determined at the margin, because strawberries have a limited shelf life. But Treasuries are like oil: they last a long time, and one Treasury is virtually the same as another, just as one barrel of oil is the same as another. The outstanding stock of Treasuries and oil (in the ground) is immense relative to marginal purchases and sales. Same with gold: all the gold ever produced is still held by someone, and new production every year is only about 3% of the outstanding supply. Gold, oil, and Treasuries are "stock" markets, where prices are determined by the balance between those willing to hold them vs. those willing to sell them. Thus the marginal buyer has very little impact on prices. If the Fed suddenly offered to pay 20% more for Treasuries than the going market price, there would be an almost instantaneous response (i.e., sales) from the owners of existing Treasuries until prices returned to a level that established an equilibrium--where the world is content to own all the Treasuries every issued.

Benjamin said...

"It's a readily observable fact that the economy has managed only a tepid recovery from its worst recession in modern memory, and it's clear that the burdens of government—spending, taxation, and regulatory—are greater today than they have ever been."--Grannis

Not sure about this.

Can you remember regulated passbook account rates?

Fixed stock-trading commissions?

Fixed airline rates?

Fixed trucking rates?

90 percent op marginal tax rates (1960s).


The old regulated telephone system?

On the other hand, very regulated today is agriculture, as it always has been. And Homeland Security is a mess on top of a mess. And mandated ethanol is larger than it ever was....

The federal tax take in relation to GDP has been stable for decades. The rising portion has been payroll taxes, falling portions have been income and corporate income spending has been financed by borrowing but entitlements largely self-financing through payroll taxes...

Things are not worse than ever have been--it just seems that way ever since Bush jr became President, and then was followed by Obama...two Presidents that hate the economy....

Joseph Constable said...

Sorry. The regulatory difference is in the social engineering required of businesses. And, environmental engineering too. The amount of regulation for safety and just plain ‘ol industry administration created by lobbying hinders the smaller and less connected players. This always happens in central planning. The winners get bigger and the losers get smaller and disappear. More and more resources are applied to unproductive activity.

Public Library said...

"It's hard to find anything out of the ordinary in the inflation stats these days."

Totally missing the plot. Good post over at the mises about "Where Is Inflation". Ben should take notice...

- Spot Oil
- Gold
- Silver
- Almost All Commodities
- Stock & Bond Markets
- Agricultural Real Estate
- Contemporary Art/Real Estate NYC
- Washington DC Real Estate
- Wine

The money is flowing from the Fed straight into sepculative activites as one would expect and not into welath generating investments.

The bust will come eventually...