« Does Unemployment Insurance Necessarily Raise the Unemployment Rate and Decrease Employment? | Main
How scary is it?
The Wall Street Journal reports:
A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher-- a climb that would jack up the government's borrowing costs and spell trouble for the fragile housing market.
This week, some investors turned up their noses at three big U.S. Treasury offerings. Demand was weak for a $44 billion 2-year note auction on Tuesday, a $42 billion sale of 5-year debt on Wednesday and a $32 billion 7-year note sale Thursday.
The poor demand, especially from foreign investors, sent the bonds' prices sharply lower and yields higher.
Paul Krugman (also here) and Brad DeLong are not concerned, noting we've seen lots of yield changes of this size or higher in the past.
Even so, whether demand will continue to be there for burgeoning U.S. debt is obviously a question of great interest. Yields are now near the highest levels we've seen since the Lehman failure in September 2008, and if they continue to move up at their recent pace I wouldn't want to dismiss it as an irrelevant development.
One possibility that I think we can rule out is that recent bond moves signal renewed worries about inflation. The recent surge in yields on Treasury Inflation Protected Securities is just as dramatic.
Also, if the WSJ explanation was the right one, I would have expected the increase in interest rates to depress stock prices. But stock prices have been going up along with bond yields.
When bond yields and stock prices rise together, I would usually read that as a signal of rising investor optimism about future real economic activity. The February numbers for home sales and other indicators that we've been receiving most recently don't exactly support that thesis. Let's hope that investors are correctly anticipating that better news lies ahead.
Posted by James Hamilton at March 28, 2010 07:22 AM
As Krugman pointed out the rate rise that the WSJ is making so much of is an increase in 10-year rates from 3.67% on 3/22 to 3.91% on 3/25.
As DeLong points out we've had many such spikes in the past. In July 2003 for example the 10-year rate rose from 3.56% at the beginning of the month to 4.49% at the end.
There weren't a lot of stories calling that spike in rates a sign of imminent US bankruptcy back then. There were however a lot of stories about increased optimism about the economy.
One unusual result of the spike is that the spread between 10-year aaa Corporate bonds and 10-year T-Bonds went negative for the first time in history. I'm surprised the bond vigilantes haven't made more of this fact.
However, although it may be unprecedented for the 10-year swap to be negative I still don't think it has anything to do with default risk. Most research show that default risk plays very little role in determining aaa corporate bond spreads. On the other hand the spread does correlate very well with the slope of the Treasury yield curve. One rationale for this is that a steep yield curve is a optimistic sign for the economy.
The gap between the 10 year Treasury bond yield and the 3 month T-bill reached 3.67% in January on average. In the 682 months for which we have data (since 1953) that's only happened in 6 months: August and September 1982, June 1984, April and May 1992 and May 2004. So it's a "tail" event. The 10 year swap was narrow in each of those months as well. Friday the gap closed at 3.74%.
And why is the yield curve so steep right now? ZIRP. When was the last time ZIRP was effectively in place? 1941. Weird things happen in ZIRP and expect more in the months to come.
Posted by: Mark A. Sadowski at March 28, 2010 07:53 AM
I strongly urge the deficit worrywart to put their money where their mouth is and short U.S. bonds. I know some investors that have done that for Japanese bonds 15 years ago... and lost their shirt as a result.
Posted by: Qc at March 28, 2010 08:12 AM
JDH,
The question is not, "why are rates rising?" The question is, "what is the implication of higher rates?"
Even a positive rising rate dynamic -- one driven by recovery expectations -- has an adverse effect on rate-sensitive parts of the economy. The stock market incorporates a view on this. That is, equity investors essentially bet that rate volatility will be low, mostly because the yield curve is anchored on the short end by ZIRP for an "extended period". Rising stock prices tell us that a moderately strong recovery will make up for the negative effect of a slight rise in long term rates.
What equity investors will not like is a "100yr flood" in the yield curve steepness. That is, if rates rise quickly while ZIRP is still in effect -- creating a 300bp+ 2/10yr spread -- then the market will be "surprised" by a negative development. Rate-sensitive sectors of the economy may be so negatively affected as to jeopardize the overall recovery. This is a recipe for a steep equity market correction.
Given that the yield curve is already at record steepness, we are in uncharted territory. Call it "crowding out", or call it something else, but a >4% 10yr does not fit with a 0% Fed Funds rate. It raises fears that deficit financing needs are keeping real yields abnormally high, and that this problem will not go away without additional QE. Another question to ask is, "how high would the Fed allow the 10yr to rise before resuming its Treasury bond purchase program?"
Krugman and others point out that nominal yields are relatively low historically. I would ask them, how high should yields be given that the short end is at zero and will remain so for an "extended period"?
Posted by: David Pearson at March 28, 2010 08:44 AM
The Chinese just reported a trade deficit for March, so there goes Timay's best customer. Unless he can get Benny and the Inkjets interested again.
But esoteric finance aside, the classic interpretation of stocks up, yields up, is a bull economy and stock market.
That is a little hard to believe from an economic standpoint, and also volume is low on Wall Street, and it is the High Frequency Trading Super Computers that are selling stock to each other.
I've got my own theory. I think that yields have to rise to a point where people think they have somewhat normalized, then they will be more willing to make a 2,5,10, or 30 year bet on Treasuries.
If you buy now you can be trapped with a paper capital loss for a long time, and if inflation does pick up you either have to sell and take the capital loss, or hold to maturity and get your inflated away face value back.
But good news for economists, this is called "raising inflationary expectations", a good thing.
Once rates are high enough, I think the Treasury market will eat the stock market, because the stock market is overvalued, certainly based on 2% forecasted GDP growth combined with the Great Bull Market PEs it sells for now.
So this way we can fund federal deficits without a lot of foreign investment. But there is a caveat, we need $9 trillion in new treasury sales over the coming decade (the thing that Krugman and DeLong are only mildly concerned about) and that would mean the stock market would be closer to DOW 3600 instead of DOW 36000. (And there goes the university endowment fund!)
Unless Benny and the Inkjets get interested in buying stocks. Could happen I guess. GLD 36000 too, most likely.
The other caveat is that maybe no one buys and holds bonds anymore, the market is all traders, and we don't know what they are thinking while trading 30 year bonds.
Unless Benny and the Inkjets .....
Posted by: Cedric Regula at March 28, 2010 09:03 AM
Odd that you don't mention the influence of Treasury's ongoing deposits into the supplementary financing account, since you're one of the few who mentioned it when it was announced.
Since late February, Treasury has been selling an additional ~$25 billion a week of Treasuries above its actual financing needs, and depositing the proceeds in the supplementary financing account. That simultaneously increases the supply of Treasuries and decreases the volume of dollars in private hands.
This monetary de-stimulus is scheduled to run for another roughly four weeks, coinciding/overlapping with the Fed's winding down of the monetary stimulus of MBS purchases. It appears that the build-up of reserves hit its peak between two and four weeks ago, and the Fed is now testing some mild tightening.
There is another way to explain why Treasury markets sold off while stock market bulls took it in stride and kept on rallying: The former are closer to the fire.
Posted by: Tom at March 28, 2010 09:10 AM
Probably some optitmism, but mostly it seems like investors see treasuries as a less safe place to park their money. If only they could feel the same way about commodities.
Posted by: aaron at March 28, 2010 09:25 AM
Investors may be raising cash to invest in the supposed spike in GSE MBS rates when the Fed stops their purchase program. Plus there is the usual end of quarter dressing the balance sheet with cash.
Posted by: Rajesh at March 28, 2010 09:45 AM
"Even so, whether demand will continue to be there for burgeoning U.S. debt is obviously a question of great interest."
Read Full Article »