Forget Equities, Bonds Are Where the Action Is
In the iconic movie Wall Street, filmmaker Oliver Stone presents as his archetype Gordon Gekko, a corporate raider who takes no prisoners. Such were his excesses that he even delivers a speech extolling greed to a fictional gathering of shareholders. Greed will, he says in the movie, “not only save Teldar Paper but that other malfunctioning corporation called the USA.” Stone presented the moment as a political choice.
It was in many ways a false one. People think of the NYSE when put upon the subject of Wall Street. It makes sense because that is what is actually there in that physical location. The stock market is the focus, or at least it is as what lies in the popular imagination. The bull market run starting in 1982 has shaped that viewpoint particularly since for the first time in history stock wealth was in reach to ordinary Americans in a way it had never been before. It is our mass connection to finance.
Finance itself in reality, however, is much different. Gekko got the screen time but the real titans were not stock traders. The true BSD’s (an actual term brought to light by Michael Lewis) were the bond guys. The real money is made, and lost, in credit. Stocks are an interesting story for the mass media, a way to keep people engaged. In the scheme of things, bonds are what rules.
Part of the problem for convention is its history of the past three or four decades. Alan Greenspan is thought the one person who could and did supplant Gordon Gekko as the exemplar of Wall Street. And he paid close attention to stocks, so much so that it was a trading rule for the Greenspan put. No way would he let stocks fall because they were just that important to the global economic order. That was the policy lesson of 1929, after all.
While it was very likely true the “maestro” followed the closing bell regularly, with stock investors returning the favor in their infatuation of all things Greenspan, the bond market was more than a little mystery to him. He had famously raised the federal funds target rate starting in February 1994 leading to what was then called the bond market massacre of that year. It was a historic selloff that lingers in the nightmares of bond traders even today.
A decade later, he did it again but bonds didn’t this time react the same way. Far from it, longer-term interest rates moved very little even though the Federal Reserve starting in June 2004 ultimately increased its target by far more (from 1% to 5.25% June 2004 to June 2006 as compared to from 3% to 6% in 1994 and early 1995). In the midst of that intended “tightening”, in February 2005 the Fed Chairman testified to Congress his confusion.
“For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.”
As with a lot of famous speeches, they get remembered for only small parts. In this case, it was just the one word, “conundrum.” Though it was and remains attributed to just Alan Greenspan, he was not at all alone in his perplexed state. Bill Gross, the oft-claimed bond market champion, in PIMCO’s March 2005 Investment Outlook confessed to having made the same mistake.
“Who would have thought that the bond market could have done ‘better than that’ –better, that is, than what it typically does during periods of rising short-term interest rates? Not yours truly, nor Alan Greenspan…I must tell you that we at PIMCO have been talking about this topic for months. We, too, have been befuddled.”
In early 2005, at only the start of the Fed’s “tightening” cycle, Gross then invoked what is commonly heard today, pondering, “…an irrationality to this market that speaks to overvaluation or perhaps even a bubble?” In late June 2004 when the FOMC voted a hike for the first time, the 10-year UST was yielding about 4.70%. Sixteen additional votes later and 425 bps upward in federal funds, in June 2006 the note was yielding about 5.25%...and then traded back to 4.70% in just the next three months. Through the whole period, longer-dated UST’s traded in a very narrow range no matter what.
Over the years innumerable academic papers have been written and huge quantities of analysis created to try to explain this “conundrum.” In his 2005 testimony, the Chairman offered a few possibilities including what he and Ben Bernanke would later publicize as a “global savings glut.” A popular and frequently cited paper published by the Brookings Institute claimed it was instead economists’ favorite Fisherian interest rate component:
“We think the evidence points to a declining term premium as the primary source of the recent fall in long-term forward rates. This interpretation is broadly consistent with observed changes in risk spreads, interest rate and stock market volatility, the dispersion in long-range forecasts, and estimates of (some) affine bond-pricing models.”
“Term premiums” are supposed to be the additional yield a bond market investor demands to hold a longer-date security of the same type or issuer. It is a direct comment, economists believe, on the shape of the yield curve and therefore a consideration of risk (related to time). The paper reaches this conclusion by rejecting “long-range forecasts of inflation, growth, and short-term interest rates provide little reason to believe that they might account for the same decline in long-term forward rates.”
That did seem to be the case, as at the time of publication inflation was running hot, growth was projected to be good and stable, and short-term rates were believed to be the sole purview of Greenspan then Bernanke. All of those factors would have pointed to much higher bond rates, something more like the market experience of 1994. But the authors of the study as well as policymakers like the Fed Chairs never took into account disagreement. In other words, they never considered that the bond market might be examining risks differently. The Brookings paper was written in Q1 2007.
Lower term premiums are in these academic terms a reflection of lower perceived future risk. You can see why economists like them that way, particularly in the case of the mid-2000’s. They turn what was a mystery into a positive commentary on monetary policy; Greenspan and economists had no idea why bond rates weren’t rising, but many of them came to believe it was because he knew what he was doing, and so they found a way to believe bond investors felt that way, too. It’s another example of why clear Fed policy failure became standard.
Going back to Greenspan’s 2005 testimony, there were other parts of it that offered a less strained approach.
“Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past twenty years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward.”
One of his major themes was globalization, particularly from the late 1980’s forward after the fall of communist regimes in Europe. The trend had, many believed, contributed to the mild inflation environment of the era. If this placidity continued for several more decades as was commonly believed, maybe the bond market was marking down inflation expectations for that benign reason.
It was called the Great Moderation due in most part, as economists James Stock and Mark Watson stated in 2003, to “good luck.” That “luck” was the distinct absence of monetary shocks in the United States during that period, a factor Fed officials like Ben Bernanke were sure was due to their great skill and innovation (trading money supply targets for specific attention to money demand).
But already in 2003 some of the luster of that mystique had come off. It was the tail end of the dot-com bust that for the first time in a generation had people questioning the Federal Reserve. For all the assumed attention to the stock market and the capacity of the Greenspan put, there was the non-trivial matter of a collapsed bubble.
This perhaps refocusing wasn’t just a financial matter. For all the promise of the late 1990’s “new economy”, the tremendous opportunity the dot-com bubble was supposed to represent, the economy of the 2000’s wasn’t living up to its billing. The 2001 recession was itself a very mild one, so minor that many if not most people attribute it to this day to 9/11 even though it officially began months before. The economic problems were not in the contraction phase, rather they ran all throughout what became a slow, extended recovery.
It was in many ways a contradiction, one among several. The recession had ended in November 2001, yet the Federal Reserve’s final rate cut, the one that brought the federal funds target rate all the way to 1%, didn’t happen until June 2003. The term “jobless recovery” became a political issue in the 2004 presidential campaign. Where only widespread prosperity of the “new economy” was supposed to happen, almost halfway into the first decade of the 21st century weakness instead pervaded despite what was outwardly massive and historic “stimulus.” Maybe the Fed wasn’t the apex of technocracy after all?
There were many other reasons for systemic reexamination at that moment. Not the least of which was inflation and effective monetary conditions; meaning that though the Fed believed it was “tightening” again after June 2004, out in the real economy and global monetary marketplace there wasn’t evidence that it was anything more than a change in policy. Inflation rates were still high, above target, and would only grow higher, while monetary conditions went truly parabolic.
Unlike Ben Bernanke who spoke with unflinching certainty, Alan Greenspan often included little moments of clarity in his thoughts and speeches. They were very often set up surrounding a puzzle that had arisen, where he professed to believe certain things but acknowledged some degree of troubling unknown about it.
His most famous “irrational exuberance” speech was one prime example. Though those are the only two words people remember, they were uttered because monetary correlations were no longer holding and hadn’t by that point for a long time before. What had guided monetary policy (money supply) for almost all the Federal Reserve’s history was no longer working. Greenspan’s warning, then in 1996, was to consider what might happen if his belief that it wouldn’t matter proved inaccurate.
In 2005, the Chairman uttered a similar doubt about the Great “Moderation.”
“Yet history cautions that people experiencing long periods of relative stability are prone to excess.”
To put it into the terms of Stock and Watson, some care had to be given to making sure our luck didn’t run out. Thus, from the perspective of the bond market, the rate history wasn’t so unexplainable. If Greenspan was “maestro” in the late 1990’s during the dot-com bubble, he wasn’t as universally hailed after the dot-com bust. Growth had disappointed on the upside even if limited on the downside. And then there was massive, enormous, mountainous monetary risks building up all over the world. It might have been officially classified as a potential “global savings glut” but most people knew it in the US as the housing bubble.
In other words, the bond market in the middle 2000’s was projecting increasing and ultimately enormous uncertainty. These were doubts that the Great “Moderation” would just continue, because for all intents and purposes it was obvious that it was no longer moderate in the ways that would matter most. That global monetary conditions continued upward even as Greenspan hiked the federal funds target would have only elicited more and deeper concern about the ultimate outcome. Full faith in the Fed was already being unraveled, in bonds, years before the crash.
Quite unlike 1994, the bond market clearly saw risks in 2004 as vastly different. Though the rising eurodollar system was behind both, the spectrum of global risks were entirely dissimilar close to its end than more so its middle (or beginning of its mature phase). Even Greenspan’s testimony in 2005 referred to it in his own backward, orthodox way, when he wondered to Congress about how “greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment.” To him that was a gentle if external global savings glut; to the bond market it was the rising risk of a very bad ending to a decades-long unchecked, and grimly unexamined, monetary free-for-all.
The problem for policymakers and economists, then as now, is that they made a habit of dictating to bond markets rather than listening. There has always been a mistrust of them going back to the Great Depression. On some levels this suspicion is encoded into the institutional DNA of the modern neo-Keynesian Fed and all its global counterparts. Their affinity for stock prices was and is in many ways a reflection of that chasm.
What would be the implications for the bond market if it were convincingly suggested that the Fed wasn’t an all-powerful institution expertly controlling the US and by extension global economy? In 2005, it would mean reassessment and hesitation, no longer fully embracing future expectations as they “should be” - but not fully letting go of them either. The probability spectrum being contemplated during that period would have been unbelievably wide, running the full range from the economy possibly fulfilling the 1990’s promise of the “new economy” to what actually happened. From these broad considerations, it is no wonder long rates remained largely stable – until July and August 2007.
The only difference in global bond markets between 2005 and today is that the Fed’s utter impotence has now been fully established, proven as an empirical matter (four QE’s and nothing to show for them will do that). These are no longer mere doubts but full-blown contempt, broken only briefly and intermittently by small springs of hope (this last one of “reflation” having nothing whatsoever to do with the Fed). The bond market isn’t some impenetrable enigma, and, apologies to Mr. Stone, it matters far, far more.