With the Fed completing a two day meeting and Bernanke holding a press conference today it may be a good time to make a few comments about bond yields.
In an open economy with a current account deficit the equilibrium interest rate is the one that attracts sufficient foreign capital to finance the current account deficit with a stable exchange rate.If the currency is rising it indicates that yields may be too high, while a falling currency implies that yields are too low.This is important to understand because the US 10 year T-bond yields rose 46 basis points in May and the bulk of the increase stemmed from a rise in Japanese yields.They surged because investors decided that Abenomics was working.This, in turn, pulled bond yields up some 25 to 35 basis points in Britain, Germany, the US and many other countries.All of this preceded the release of the Fed minutes and Bernanke’s Congressional testimony. Yet Wall Street and many bloggers seem to ignore the point that two-thirds of the May bond yield rise was due to foreign factors, not the possibility of Fed tapering.
I overheard a conversation at a local restaurant on the impact of the US being dependent on China buying US bonds to finance federal debt. Usullay missing from such conversations is the % of money involved, whether that is a lot, and what effect it has on federal debt and trade (and some kind of political or ‘war’ value?) Then via Mark Thoma came the Krugman piece on bonds and how the market works in Fear of China syndrome, so thought I would post the Krugman piece and some comment by Mark Sadowski from the post:
Paul Krugman tries, once again, to explain why there’s no reason to fear that “terrible things will happen” if China stops purchasing our government bonds:
The idea that we are at the mercy of the Chinese — that terrible things would happen if they stopped buying our bonds — is very influential. Yet it’s just wrong. Think of it this way: the argument that interest rates would soar if the Chinese bought fewer bonds is the same as the argument that interest rates would soar when the U.S. government sold more bonds — which, as you may recall, was the subject of fierce debate more than three years ago — and you know how that turned out.
Again, you can think of this in terms Wicksell: we’re in a situation in which the incipient supply of savings — the amount that people would save at full employment — is greater than the incipient demand for investment. And this excess supply of savings leads to a depressed economy.
What China does by buying bonds is add to the excess savings — which makes our situation worse. (This is just another way of saying that the artificial trade surplus hurts our economy — just another way of stating the same thing). And we want them to do less of it; far from fearing that they will stop, we should welcome the prospect.
Lifted from comments from Economistview:
Mark A. Sadowski said in reply to Matt C…
This is old news. FYI QE2 ended in June of 2011.
On June 30, 2011 the Fed held $1,617 billion worth of Treasuries: http://www.federalreserve.gov/releases/h41/20110630/
According to the most recent release (August 30) the Fed now holds $1,639 billion worth of Treasuries. http://ftalphaville.ft.com/blog/2012/08/31/1140881/if-qe3-is-so-close-why-is-the-feds-balance-sheet-shrinking/
According to SIFMA: http://www.sifma.org/research/statistics.aspx
$1,274 billion in Treasuries were issued between the end of June 2011 and the end of July 2012, meaning the Fed has bought less than 2% of all Treasuries issued in that time.
Moreover, the Fed’s balance sheet has actually been shrinking since December. That’s why there are tons of stories such as this if you bother to do the google: http://ftalphaville.ft.com/blog/2012/08/31/1140881/if-qe3-is-so-close-why-is-the-feds-balance-sheet-shrinking/ .. Correct current release link: http://www.federalreserve.gov/releases/h41/Current/
Matt C asked: Even if QE2 is old news, what is the big change in the financial landscape since 2011?
Was it not bad in 2011 for China to be buying bonds then? If China was depressing the economy by buying bonds then, why wasn’t QE2 doing the same thing?
Mark A. Sadowski answers: It makes a big difference who’s buying the bonds.
Krugman describes the situation as an excess of savings over desired investment. But another way of looking at it is as an excess demand for money over its supply.
When the Chinese buy US Treasury bonds they increase the demand for US dollars and drive up the dollar’s value (they were of course doing this intentionally to increase their net exports). When the Fed buys bonds they’re adding to the supply of dollars. This of course drives down the value of the dollar.
Increased demand for dollars is depressing. Increased supply of dollars is stimulative.
The current low level of long term interest rates is creating all types of debate about what it is suppose to signify and what investors are discounting.
Maybe they are not signaling anything and it is just a return to normal for interest rates. For example, from 1871 to 1960 long Treasuries were below 4% some 75%of the time. Over the long sweep of history very low rates were more the norm than the high rates of recent decades. Maybe the recent history was the exception and we are now just returning to a more normal level of rates.
P.S. I came back later and replaced the first chart back to 1921 with one back to 1871.
Simon Johnson comments on Standard and Poor’s irrational ratings:
Standard & Poor’s downgrade of United States government debt last month has been much debated, but not enough attention has been devoted to the fact, reported last week by Bloomberg News, that it continues to rate securities based on subprime mortgages as AAA.
In short, S.&P. is suggesting that these mortgages are more creditworthy than the United States government — a striking proposition. Leave aside for a moment that S.&P. made a big mistake in its analysis of the federal budget (as explained by James Kwak in our blog). Just focus on all the things that can go wrong with subprime mortgages: housing prices can fall, people can lose jobs, the economy may fall into recession and so on.
I know that some readers are going to say “Wait. The gold market is saying inflation, not deflation.”
That’s not how I see it. I see the negative real rate on cash parked in T-bills (three month yield 0%, 12 month yield 0.08%) as a clear indication that prices are going down, not up. As more and more market participants equate gold to another currency, they are simply diversifying their cash into that currency along with Dollars, Pounds, Swiss Francs, Yen and Euros. If you consider the total bullion supply, the allocation into gold is less than $10 trillion worldwide, a small fraction of the total debt held as investment.
The key to understanding the mixed signals of gold and the bond market(s) is to realize that boiling every bit of information in the market down to a single price eliminates much of the information. Once that information is reduced to a single data point, you can’t actually re-create it. We’re left guessing at what forces are at work that put the prices where they are.
The one thing that makes no sense is to look at one market (eg gold) and conclude that there is inflation ahead while ignoring other larger markets that are telling the opposite story.
Even though Europe is on the forefront of global bond news these days, I’d like to revisit the US Treasury market. Specifically, I’ll look at the Canadian-US bond spreads, which tell an interesting tale of Fed purchases and US deficit fears.
First, the Canadian over US government bond spreads for two longer term issues, 10yr and 30yr in chart below, have been falling for some time. Today (Jan. 10, 2011), the 10-yr Canadian Treasury over the 10-yr Treasury spread is around -12 basis points (bps), i.e., the Canadian 10-yr bond is 12 bps lower than the US 10-yr. The 30-yr spread is roughly -86 bps.
The recent divergence of the ‘spread’ between these two spreads presents a bit of a conundrum, since the two have more or less moved in lockstep.
Note: in the chart above, each dotted line represents the period average for the 30 calendar day (30-c.day) moving average spread of similar color.
The conundrum is this: the 30-yr spread has deviated well below its 2002-2011 average of 8 bps, while the 10-yr spread is sitting roughly at its average, -13 bps. But this is not a conundrum if you consider recent US policy, holding all else equal.
One the one hand, the Federal Reserve is concentrating its bond purchases in the long end of the curve, primarily below the 10-yr maturity. According to the NY Fed, 23% of the $600 bn will be allocated to the 7yr-10yr part of the curve, while just 4% will support the 17yr-30yr end. Therefore, and holding all else equal, the CAN-US spread proxies somewhat the effects of Fed policy in the bond market. The Fed is supporting the 10-yr spread roughly at trend(Section II in chart above), while contemporaneously raising inflation expectations relative to that in Canada.
On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada. This is a similar premium that was attached to Canadian sovereign debt in the early- to mid- 1990s (Section I in the chart above).
Compare the chart below, which illustrates the annual federal deficit in the two countries as a percentage of GDP, to the chart above. Notice how when the red line, (Canadian government deficit) moves aboe the blue line (US government deficit), the average spread drops (Section III in first chart)? That premium is now feeding into the 30-yr spread at an increasing rate (Section II of first chart).
I am in no way suggesting that the US should undergo a similar fiscal austertiy program as that taken in Canada in 1995 (please see Stephen Gordon at Worthwhile Canadian Initiative). What I am demonstrating, though – and rather qualitatively, I might add – is that absent active Fed purchases in the back end of the curve, there is a risk premium emerging in the US bond market relative to that of at least one country with markedly lower government deficits, all else equal, of course.
Many are talking about the bond market being the latest bubble. But it looks more like the press is just seeing bubbles everywhere. To me a bubble happens when everyone starts believing something that probably is not true. For example in the 1990’s investors started thinking that the long term earnings growth of the S&P 500 was shifting up from its long term 7% growth rate. So they believed that the market was worth more than historic valuations implied and the market PE rose to the 25 to 30 level.
In the 2000’s bankers and home owners came to believe that housing prices could never fall so that homeowners could always refinance their mortgages. Consequently, lenders did not have to worry about credit risk.
So for the bond market to be a “bubble” investors would have to start thinking they can make unusually large capital gains in the bond market. But everyone knows that if you buy a 10 year bond that at the end of 10 years all you will get back is your original investment. In the meantime you will get the coupon and what you can earn by reinvesting that coupon. Yes, if rates continue to fall in the short run you will be able to sell the bond for more than you paid, but you total return has to remain limited because in 10 years the possibility of capital gains must converge on zero. As long as this is true the possibility of a bond bubble must remain something reporters and pundits can pontificate on but nothing more than that.
We have seen the argument from some commission participants (Peterson for one) that Social Security is too expensive for those who need it and pay for it because it is an ‘entitlement’. We also have read from some Congress members (Senators Kyl and McConnel) that tax cut extensions of the Bush presidency are not deficit producing and need not be part of pay go.
The Fiscal Times has an article on considerations being undertaken by the Commission for Deficit Reduction. (H/t coberly).
The main theme in this article is that the “tax expenditures” home mortgage deduction and health insurance premium deductions are actually government spending (I assume in relation to the deficit) and thereby letting these taxpayers keep their money is bad. (Because these are “tax expenditures” and not “tax cuts”?)
I see a pattern here unfolding in this series of electioneering statements. Maybe politicians can put it altogether for us before the elections so we know who should pay and who should not in a less confusing way.
Quote is below the fold, bolding is mine:
As the 18-member bipartisan panel met in public for the fifth time, it was becoming clear that the tax system is under its microscope and there are many ideas under review for the long term. The commission’s success has always hinged on whether its leaders could muster support among Republicans for changes to the tax system, and agree to major spending cuts and changes in Social Security, Medicare and other entitlement programs that dominate the budget. So far, the GOP members are still at the table.
The most obvious target is recovering the huge amounts of revenue lost to federal tax loopholes known as “tax expenditures,” which include the home mortgage interest deduction and tax-free health premiums for employees. Proponents of rolling back these breaks say they are essentially government spending via the tax code. But health care premiums and mortgage deductions have long histories and are considered untouchable by some.
Erskine Bowles, one of the commission’s co-chairmen, pointed out that these loopholes cost the Treasury as much as $1.3 trillion per year, which is larger than total tax revenue. Bowles, citing an op-ed by Reagan White House economist Martin Feldstein, suggested that tax expenditures must be part of any serious attempt to limit spending.
Maya MacGuineas, president of the Committee for a Responsible Federal Budget, told the commission that the current system of tax expenditures is “one of the most detrimental things to the country.” But she also pointed out that they would be among the more difficult programs to touch.
Senate Budget Committee chairman Kent Conrad, D-N.D., who leads the commission’s working group on taxes, said that he has become convinced that more comprehensive tax reform is necessary to update a system that was built for an era in which the United States did not face global competition. “My own conclusion from this [working group review] is that we really have a tax system that is badly outdated,” he said. “It no longer relates to a world that we are in today.”
In addition to massive lost revenue through tax expenditures, the Treasury loses another $340 billion or so each year in taxes that people owe but simply do not pay, Conrad pointed out. “These are things that require a focus in our work.”
Here are some charts to demonstrate what I was talking about. the recent drop in US bond yields has not been accompanied by a similar drop in European rates. Consequently the spread between US and foreign bonds has narrowed and it no longer compensates foreigners for the currency risk they take when investing in the US. The consequences are a weak dollar. Note the opposite happened when Reagan first created structural deficits and the dollar had to weaken enough to create a large enough trade deficit to facilitate the capital inflow. At that point we had crowding out but it worked through the dollar to crowd out the manufacturing sector rather then the interest sensitive sectors.
It is also working against the Euro as you see the it strengthen when rates spreads widen.
When the US made itself dependent on foreign capital inflows the world got a lot more complex and it was no longer possible to analysis monetary or fiscal policy as if the US were a closed economy. I worry that we are now starting to see the bear case that I have worried about for years when international capital flows prevent the Fed from easing when domestic considerations call for it. I’m not making a forecast, I’m just laying out factors that make the analysis much more complex and that need to be brought into the analysis.
Maybe it is what we need to revive the manufacturing sector, and will be what drives the economy over the next decade. Save-the-rustbelt would love this. But, it creates inflation and real income complications for the rest of us.
I probably is what will happen since Don Boudreaux at the Cafe Hayek blog just got one of his letters to the FT published where he praised the trade deficit. I just base my analysis on the thesis that he is usually wrong.
I realize these charts are simple and the real world is more complex involving covered interest rate difference, etc, but they are adequate to make the point.