Where Are The Bond Market Vigilantes? Floyd Norris Jumps On The Bandwagon
I took some grief (and some praise) for two posts (here and here) from a week or so ago that said the bond market was unambiguously signaling that the current economic situation warranted deficit increases rather than reductions and that it had no problem with that. Now Floyd Norris at the New York Times has come to the same conclusion as I did. The money quote:
But for now, the financial markets seem to fear recession and deflation much more than they fear deficit spending.
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For Now
And, the money words are "for now". Public debt incurred by deficits doesn't merely go away. It stays around and grows until the inevitable market change. That's when interest rates rise and the real trouble begins. Sometimes I think Mr. Collender would be a great salesman for subprime adjustable rate mortgages.
Teh Treasury needs to be
Teh Treasury needs to be aggressively lengthening the average maturity of the public debt at these interest rates. Need to be issuing more 10 years and fewer 3 month bills. Since the market seems willing to buy anything with a T on it, might as well lock in these low rates for the long term, even if it costs a little bit more short term.
Payment Shock
Further to the above post, the problem with Collender’s attitude toward public borrowing in a short-term low interest rate environment is that it ignores the fact that these rates can, and inevitably do, change.
The average rollover of marketable Treasury securities is now over 55 percent Currently, Treasury is funding the public debt at an average maturity of 55 months, well below the historical average of 60 months in order to take advantage of relatively lower short term rates. Further, as surveyed by Treasury, institutional investors have recently indicated they will have a higher appetite for TIPs in future auctions as they fear higher inflation and interest rates. All of these factors indicate the fact that current interest rates and borrowing costs are no indicator of long rates or costs. This type of thinking carries very serious risks. . As we have seen with the cases of Greece and Ireland, average borrowing costs can increase significantly in very short periods of time as public debt is rolled over.
Rather than look at current interest rates, a better metric of how much debt an economy can withstand over the long term is the public debt to GDP ratio. Here, the statistics are quite sobering. Public debt to GDP was 53 percent and is projected to be 70.1 percent next year, steadily rising to 90 percent in 2020.
Yet another way to look at it is to measure public debt by the ratio of such debt to public revenues. Here is what the GAO had to say:
“According to CBO, interest rates and the size of debt held by the public
will increase in the medium term, leading to higher interest costs for the
government. One way to measure the affordability of debt held by the
public is to compare interest payments with expected revenues. As seen in
figure 4, according to CBO, net interest payments as a percentage of total
revenues will increase from 9.9 percent in fiscal year 2010 to 20.7 percent
in fiscal year 2020”.
http://www.ustreas.gov/press/releases/tg529.htm
I find it highly irresponsible for public figures such as Collender to be touting higher public deficits on the basis merely of current interest rates without even mentioning the very significant risks that are involved by pursuing this very short term strategy. Perhaps he should read the following consumer protection advice published by the Federal Reserve:
Payment shock may occur if your mortgage payment rises sharply at a rate adjustment. Let's see what would happen in the second year if the rate on your discounted 4% ARM were to rise to the 6% fully indexed rate.
As the example shows, even if the index rate were to stay the same, your monthly payment would go up from $954.83 to $1,192.63 in the second year.
Suppose that the index rate increases 1% in one year and the ARM rate rises to 7%. Your payment in the second year would be $1,320.59.
That's an increase of $365.76 in your monthly payment. You can see what might happen if you choose an ARM because of a low initial rate without considering whether you will be able to afford future payments. http://www.federalreserve.gov/pubs/arms/arms_english.htm
The quote attributed to
The quote attributed to http://www.ustreas.gov/press/releases/tg529.htm is not found in that document.
Link to GAO Report
Here's the correct link to the GAO report. Quote is at page 9. Sorry for the bad link, but the Treasury news release is interesting, too.
Vivian, what's your point?
Vivian - You clearly know your bond markets, but Stan's basic argument is un-refuted. The bond market is paying 3.2% on a 10-year bond. Clearly they're not worried about inflation in that time period. Rates lower than this would reflect deflation...and no economy has ever done well in a deflationary period.
You could argue that government spending doesn't help economic growth (I don't see how, but you're welcome to). You could argue that the bond market believes that the current political climate will prevent more spending and that those expectations, if shaken, would result in a large movement reflecting deficit fears (more reasonable in my estimate). But it is certainly a safe assumption that, with essentially 0% inflation built into these returns for 10 years, that the bond market is not signalling the need for austerity. That's Stan's main point, as I see it.
That's 3.2% on a 30 year bond, sorry
It's only 2.6%, after rising .7 percent today, for a 10 year bond.
What's the Point
If you need to understand Collender's point, you need to ask him. The point seems to be that because interest rates are low now, the government should borrow away. That's nonsense.
I don' know if I can make my point any easier to understand, but here goes, again. Interest rates are now low, there is no argument with that. We could argue, however, as to why rates are now low. The rates could be low because investors and traders don't expect inflation because they expect a lousy economy for the foreseeable future. Is that an argument for government borrowing? I don't think so. Presumably, the argument is that the borrowing and associated spending will lift the economy (and therefore interest rates and borrowing costs on that borrowed money). Be careful what you hope for. This argument seems to be 'borrowing and spending pays for itself' which is the flip side of "tax cuts and spending pays for itself'. I don't see the difference except they reflect different party line ideology.
Alternatively, the markets could be holding down interest rates because of excessive risk concerns and flight to safety--- not a verdict about future inflation and interest rates. These concerns could, ironically, be partly about misguided public fiscal policy. It could also involve an element of opportunistic trading. Probably, it is a reflection of all the above factors, and then some.
The main point, however, is that during my lifetime which spans more than a few years, I have never witnessed any period in which the government has actually repaid any of its outstanding debt. If you think that the money borrowed now at low interest rates will actually be repaid when rates move up, you are delusional (like Mr. Collender). No, the debt will need to eventually be re-financed at higher rates--potentially much higher rates. This is, to some extent reflected in the CBO projections. Collender seems to assume the rates now reflected in this market will hold steady in perpetuity. As noted in the prior post, the Treasury is constantly refinancing its debt. Rates on this can change very rapidlly---during a one year period in 1980/1981 as much as 5 percent or more.
If you want to know the potential consequences of this in plain Englsh, please re-read again the little cautionary tale above that the Fed provided to consumers on ARM's. The same logic applies here, except that unlike ARM's, Treasury's enjoy no interest rate caps and there probably will be no bail out from friendly governments. That's why I say Collender would make a great ARM salesman---he's got all the arguments in favor, but ignores all the risks. There should be a consumer protection rule against that. This is another disaster in the making.
One more thing
Also, a teensy weensy bit of debt was actually paid down at the end of the Clinton years, so it has happened in your life time. I don't see it happening again, though.
Paying Down Debt
John,
I was aware that at the early part of this century (from 2000 to 2001) "public debt", i.e., the amount of debt officially held by the public in the form of Treasury obligations, decreased by approximately $90 billion. However, during the same period of time, "gross debt" (which would include government borrowing from the social security trust fund) actually increased by approximately $140 billion. So, I would agree with you only to the extent that one does believes government promises to repay its notes to the social security trust fund does not constitute "debt". Either way, this is of little comfort to me.
Viv
Vivian, I don't disagree with
Vivian, I don't disagree with you entirely, but there are problems here. I'll quote you: "The point seems to be that because interest rates are low now, the government should borrow away." Sorry, but I'm sure you know what's wrong with that. (I can tell you're smart, so you have no excuse!)I can't find anything in Stan's posts that encourages the treasury to "borrow away."
For example, he says:
"With unemployment high and capacity utilization low, the bond market not only isn’t worried about the excessive economic growth, it actually would welcome the additional activity that would be generated by higher spending and lower taxes."
and
"With unemployment high, economic growth slow, interest rates low, and the bond market and Federal Reserve all signaling that more needs to be done to change the outlook, deficit reduction would actually be harmful -- a repeat of Herbert Hoover-like policies that would prolong the slow recovery."
Stan is responding to the "listen to the market" people, who also happen to be deficit hawks much of the time. He's saying to them,"I am listening to the markets, and they say more stimulus." That's it. It's more a rebuttal than anything else.
You're obviously right that rates will go up. They are going to have to "normalize" at some point, which will at least double interest payments made by the treasury. The point, however, is that they're not likely to normalize before 2012, and it's from now until then that the economy would need the additional stimulus. Tightening now would be worse than borrowing now, as bad as more borrowing may be.
What the Markets Say
John,
It appears as though you are "smart enough", so perhaps I can convince you to see the rest of the light. First, my point is that Collender and others are not only listening too much to the (bond) markets, they are misinterpreting whatever those markets might legitimately have to say about the deficits. With respect to listening too much, please re-read my reply to Collender's earlier post wherein I argued this sounds like a repeat of the housing fiasco---was it not Greenspan and others "listening to what the housing market was saying" that was largely responsible for the failed government policies that got us into this mess? Markets can and do, rapidly change. Risk management, particularly with respect to our government finances, needs to take that into account.
Second, I think they are misinterpreting what the markets might be saying, if anything, about the deficits. Collender and others seem to be under the spell of Krugman, whose take on this is obviously political. As I have indicated several times, the prices reflected in the bond market reflect much, much more than expectations about inflation. Folks here seem to think there is a one-to-one correlation, and an accurate one at that. That is simply not the case.
Again, we should leave it up to Collender to tell us what he means. However, my take here, even after re-reading and re-considering the comments you quote, is that he is arguing "borrow away" and spend it and that the bond markets are telling us they want the government to do so. The biggest problem I've got with his statement is the spending part. If his intent were otherwise, I suggest that he would have balanced his enthusiasm for such borrowing by listing some of the dangers of that approach which I have brought into this discussion. Finally, if he is correct that the bond markets want us to borrow more and incur more deficits, this would be the first time in my memory that such sentiment has prevailed among bond investors.
With respect to Herbert Hoover, I don't think the comparison is fair. Herbert Hoover raised taxes dramatically in 1932--a big mistake. Marginal personal tax rates rose from 25 percent to 63 percent, the estate tax was doubled and corporate tax was increased by 15 percent. That is something to think about in this coming season, but I think here is the bottom line: this is not the time to slam on the brakes (Hoover) nor put the pedal to the floor (Collender?). This is not the time for herky jerky driv'in and I don't think I want either of them to be at the wheel. We may have to move along in first gear for awhile while we de-leverage, but if we do, eventually we'll pick up speed. At least the ride will be more comfortable and the view better.
Vivian is right
I manage money and it's much more complex and there are a lot more variables at work right now than the simplistic notion that the bond market is signaling they want deficit increases.
It just doesnt work like that. Is the bond market worried about deflation and double dip like Stan mentioned ? Absolutely. there is also the trading element that pushes rates in either direction looking to make money on the price changes.
Look at oil when it went to 100+ so quickly. Money moves in and then it moves out.
People are making large bets right now to make money on small changes in the yield curve. Money piles in and money can pile out. Those people buying right now arent telling you they want the govt to borrow more. They are following momentum. A lot of money buying 10 year paper has no intention holding it 10 years. heck they might hold it 90 days
Also so much money has gone flight to quality and is practically willing to tell the govt to just hold their cash right now no matter what they pay in interest.
To Vivian and Mike, I have to
To Vivian and Mike, I have to agree that the bond market is likely saying something much more nuanced and complex than "borrow away." But if a huge glut of money has flowed into bonds because of the 'flight to quality/liquidity' phenomenon, it begs the question, where else can it go if/when it flows out? Where can all that money flow to? Gold? Commodities in general? That's a strange place for it to go because those markets tend to be so much more volatile than the treasury market. I just can't think of anywhere realistic for that money to go, which makes it quite different from the situation in Greece.
In any case, I can accept that the bond market might actually want a reduction in deficits, and that it has been bidding up treasuries for reasons unrelated to federal borrowing. But assuming that the bond market is actually saying that it doesn't want more borrowing, isn't it also saying it wants all the Bush tax cuts to expire? If the bond market is smart, it can't possibly think that anyone's about to make spending cuts in the hundreds of billions, which means borrowing will be needed to extend any of the tax cuts. What do you guys think?
Great questions John
As for your questions in the 1st paragraph about where the money can go ( that has gone into bonds ) I'd say let's break it up into 3 categories for now although there are really a couple of others but to simplify it lets stick with these. You have private investors via mutual funds whom last year put somewhere near a staggering roughly $420 billion dollars in bond mutual funds ( as per a forbes article sometime in the beginning of this year ) compare that to an outflow I think of $30+ billion ( I think from the same article ) out of equity mutual funds in 09. Meanwhile the market was up big in 09 and a lot of people missed the boat. This money I'm not so sure will move fast anywhere ( if anything they will be the last ones out most of the time ). A lot of this money was from people who had it with equities and not making money and want yield. Now bond funds by nature stay relatively fully invested so whatever money they get chases bonds most of the time no matter the market. Unless there is a big correction I personally dont see that money moving out anytime soon as long as rates are so low but if the market rallied big from here you could see some of that money chase performance after the fact.
2nd category I'd say is flight to quality. Hold my money no matter what the yield. I'd classify this as a lot of the short term money. That money will stay until maturity and if really needed is ultra liquid and can be sold without big losses due to short duration so its flexible in case money needs to be put somewhere else.
3rd is momentum money. My belief is that there is a lot of this money on the intermediate to longer end of the curve because of several factors ( and this is the money most likely to move out when needed which might not be for a while ). This is money that has no other home right now because no one is really sure where to make money ( where oil was an easy bet a while ago it no longer is and you have the s&p stuck in a trading range. So this money looks at bonds/yields and sees an economy with potential double dip,fed wanting to keep interest rates low who wont be raising right now in my opinion till 2012 at least because of non inflation but more importantly bad job numbers which wont get a lot better. Couple all that with what happened after the Greece scare ( look where the 30 year was trading before that several months ago when people were talking about it breaking above 5% and where it is now ) so that definitely had an affect. Anyway when you have all these factors you can make large bets In my opinion when you have no other avenue where you are quite sure to go so you bet interest rates going lower short term because there are no real short term factors to spike them against you so it was a reasonable reward without a ton of short term risk and if it turns against you you unwind without getting clobbered knowing others are still chasing yield.
This 3rd category is the money that will exit at some point. It could go anywhere and it will once they think their is little reward left compared to other areas. I doubt it would all go to gold. Part could go to oil. Part could go to other commodities. Part could flow to dividend paying stocks who knows. But once it flows people follow the heard. Everyone was trashing the Euro months ago on cnbc and everyone was trading against it and now what happens. It rallies against the dollar and none of these knuckleheads talks about it anymore. Long story short this 3rd category money will flow somewhere. it always does
For me I'm more of a value person and I dont see value in treasuries so I stay away. Doesnt mean I'm right but thats just the way I feel personally
Sorry for the long winded response
As far as your last paragraph
I think the bond market knows some of the Bush tax cuts will expire. I think the bond market is saying repubs are taking a lot of seats and gridlock is coming. Gridlock will mean repubs actually try to act like repubs and stem the embarassing slide from the GWB years and at least pretend to be fiscally responsible. But I also think right now the bond market is acting on a show me know basis and more on a very short term memory which sees an economy starting to sputter and someone I think JP just took down gdp estimates today
Bond Vigilantes
A quote from the recent column by Pete Davis here at CG&G:
"At 2:15 PM yesterday, the Federal Open Market Committee made a big symbolic move, announcing it would buy Treasury debt in the 2-year to 10-year range to keep its $2 trillion of securities holdings constant. Otherwise, the portfolio of agency and mortgage-backed debt would have run off at $10 billion to $20 billion a month as homeowners prepay mortgages. Although that would have been a miniscule tightening of monetary policy, the Fed acted to support economic recovery. It is also the first step toward future inflation. The Fed is already bumping into its self-imposed limit on purchasing no more than 35% of any Treasury issue. With no signs of major deficit reduction from Congress yet, the Fed may have to buy a lot more Treasury debt in 2011 and beyond".
So, here is something to ponder. Why doesn't Paul Krugman and his acolytes mention that the prime player in the Treasury market today is the Federal Reserve? The Fed is buying up to 35 percent of Treasury's sold at market auctions. What they are doing is taking mortgage repayments from their portfolio and plowing the proceeds back into Treasury's in an effort to keep rates down. Is this a normal bond market? I don't think so. If you are wondering who the bond vigilantes are, it is the folks at the Fed.
Similar experience with government intervention in the currency markets suggests that it can work, but only for a time. Eventually, the Fed will need to raise its short term rates and reduce its intervention in the Treasury market. When this happens, and it must eventually, it will have a big effect on rates and the cost of servicing the debt.
I would be very concerned about this. This fed policy is driving ordinary savers out of the stock market and out of cash into bonds in search of higher yields and in the mistaken belief that there is safety in bonds. This has the effect of depressing the very yields they seek and those urging larger deficits are misreading it as a lack of fear of inflation. Much of the smart money may be able to act quickly when the transition occurs, but it is the small guy who is putting his trust in bonds who is going to get hurt, once again.
Another thing: If the tea leaf readers here think the bond market is merely telling them not to fear inflation, how do they explain the explosive increase in the gold price over the last year or two?
Floyd Norris Jumps Off the Bandwagon
Is Floyd Norris jumping off the bandwagon? In an article today in the NYT, Norris reports that in the first half of 2010 the percentage of Treasury debt purchased by non-US persons declined substantially. Norris has this to say as to the possible reason for the increased percentage of domestic purchases:
"It is not clear, of course, how much that appetite for Treasuries reflects an eagerness to lend money to the United States government as opposed to a fear of losses from alternative investments".
http://www.nytimes.com/2010/08/21/business/21charts.html?hp
So, perhaps it is not due completely to their lack of fear of inflation. Could it be that some of these domestic purchases qre by the federal reserve?
Vivian, you are definitely
Vivian, you are definitely right that the Fed is having enough of an effect out there so as to consider this a less than normal bond market. But remember, the Fed only has so much power. The newest 10 yr rates (2.65%, I believe) reflect not what the Fed thinks about the government's creditworthiness, but what the biggest broker-dealers in the world think about the government's ability to service its debt. (Remember, the Fed doesn't buy bonds from the treasury, but in the secondary market.) The last auction had a bid-to-cover ratio of somewhere around 3.3, which basically means that a bunch of sophisticated bond investors were willing to lend the government 3.3 times more than it was seeking to borrow -- not bad. That's a ratio to pay attention to, but at the moment it isn't saying anything alarming.
Again, rates will have to go up eventually, obviously this is true. But I'm not sure that it would be that catastrophic. First of all, there's no way the FOMC will allow rates to go up too quickly; they'd be much more likely to err on the side of higher inflation than possible deflation. Second, we have to keep in mind what the net interest on the debt could go to. The FY2009 net interest payments had taxpayers on the hook for $189 billion (at record low rates, of course). The treasury took in about $2.1 trillion in total revenues for the same period. Net interests costs were thus about 9% of total revenue.
If the interest costs doubled, tripled, or even quadrupled, it would be bad. But the economy likely still wouldn't collapse. A significant increase in net interest costs like this would also make spending cuts to other programs/services infinitely more politically viable than they are right now. It would be markedly different than now, when even Republicans are afraid to give a straight answer on what specific spending they'd cut.
Of course, if it were politically popular to cut spending to ensure that rates on the debt didn't climb any higher, (which it would be if interest costs were quadruple what they are now), then it would likely cool off any real bond vigilantism. That is, the higher rates climb, the more political will there will be to actually get the fiscal house in order, which would likely prevent bond vigilantes from demanding 15% interest (like in Greece). Absent a real threat like this, congress doesn't have that many good reasons to cut spending or raise taxes.
Finally, speaking of markets making complex statements about inflation/deflation, the gold market is another funny one. The gold market does not simply react to inflationary fears, but deflationary fears too (and fears about government intervention in general, which there are a lot of right now). This last crisis in some sense "proved" that gold can be a hedge against deflation. At the very least, it showed that gold and inflation are nowhere near as positively correlated as they are often made out to be. So the current price of gold does not negate anything I, or any of the other "subprime ARM salesmen" and "tea leaf readers," have said.