The Bond Market Keeps Telling Us How Clueless Global Officials Are

The Bond Market Keeps Telling Us How Clueless Global Officials Are
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What is it about term premiums? If you were to ask any Economist, they would tell you a term premium is the additional return a bond investor demands in order to lend money for a longer period of time. A premium for more term. Even the US government must pay. Should the government wish to sell, say, a three-year note, whomever is buying it will demand some additional yield above what the government offers on a two-year security.

It sounds simple and straightforward, easily intuitive.

Irving Fisher long ago decomposed bond yields into these kinds of constituent pieces. This Fisherian deconstruction is accepted as three parts: term premiums are one, inflation expectations another, and the anticipated path of short-term money rates the last.

You cannot observe a term premium – though it seems like it should be a matter of simple mathematics. Take the yield on the two-year note and subtract it from the yield on the three-year; voila, term premium.

The world, and the bond market, is much more complicated than that. What any bond investor might be anticipating in Year 2 could be very different from what any bond investor might be thinking about Year 3. A term premium alone might explain yield curve differences, or shape, but those other factors play a key role, too.

If you and many others like you begin to feel nervous about economic or financial prospects in the future, you might begin to change how you invest in bonds. A growing market consensus for lower inflation for whatever reason or reasons which might hit between Year 1 and Year 4 would alter the very structure of the curve and the yields which fall within that time segment.

Therefore, if term premiums remained the same, that is you still demand some extra compensation for being locked into a similar instrument for an additional year, and the expected path of short-term interest rates is the same, nothing more than lower inflation expectations would suggest perhaps a lower interest rate at the three-year maturity than otherwise.

That wouldn’t necessarily mean the nominal yield becomes less; it could be the case where the upward slope of the curve between the two-year and three-year maturities is significantly flatter. If you relied on the simple mathematics, you’d be conflating issues. What might look like a lower term premium is instead lower embedded inflation expectations.

What happens, though, is that lower inflation expectations never materialize in a vacuum. Usually oil prices are involved in setting them, sure, but so is some detailed sense of why generalized inflation might weaken in discrete time periods.

This sort of thing isn’t usually associated with good overall economic conditions, so in addition to reevaluating inflation expectations bond investors are probably going to take a second look at their views on how they think short-term rates will unfold. If there is a risk inflation significantly disappoints, then there must also be some risk that a central bank might be forced to respond to what’s going on. Perhaps a rate cut maybe two.

Thus, as inflation expectations soften it stands to reason expectations about the future path of short-term interest rates would, as well. The more convinced bond investors might be of the former, the more they would question the latter.

And it works both ways. If you start from the position that the economy is more likely to be bad in Year 3 as opposed to Year 2, bad enough the central bank will have to take action, that’s probably not a conducive environment for inflationary pressures, either. It isn’t necessarily a single bloc inside the nominal yield, but the inflation expectations and short-term rate components do coincide more than not.

What also happens more than not is how central bankers see themselves and their work. It is always and foreverassumed that monetary policies are effective at both inflation and economy. Convention says the Fed does something and therefore the bond market is merely Pavlovian in its response.

Take QE, for example. In the official handbook this is absolutely effective stuff; best of the best. Since no one would ever fight the Fed, and no one ever does in the econometric models the Fed uses, bond investors are modeled to react to QE quite predictably. Their expectations for inflation will rise as will their view of the future path of short-term interest rates.

The bond market, we are told, looks upon powerful monetary stimulus as powerful monetary stimulus, the end result of powerful monetary stimulus being an inflationary breakout which, given the current environment, should mean a little more inflation and higher short-term rates (which are only to make sure inflation is a little rather than a lot more).

Put those two pieces together with natural term premiums it becomes a steepening yield curve rising nominally all across the maturities. A sight to behold, an end to the lost decade.

That isn’t what happened, of course. Yields never rose that much during what were supposed to have been the best of times (2017 and the first half of 2018). Since last November, you might have noticed they’ve been falling rather precipitously.

Ben Bernanke, Janet Yellen, and now Jay Powell all still believe QE was powerful monetary stimulus, that it had very positive effects on the economy, and that the end result was and still will be a very definite, sustained pick up and acceleration in growth and inflation. That interpretation has already led to (some) rate hikes as everyone had planned.

Under their dogmatic analyses, the bond market absolutely believes as they do – how could it not? But that leaves them with a key conundrum. How can interest rates be falling and the curve flattening, distorting, and inverting?

If you are stuck on QE being awesomely effective, then you are left only with one possibility to attempt an answer. By believing in QE and therefore the economy of QE, your inflation expectations must still be rising and higher, your expected path for short-term interest rates must be rising and higher, which means the only thing left to account for market behavior is the plug line – term premiums.

Should nominal rates fall far enough, and you stubbornly refuse to change your mind about the other two components, then you’ll have to concede that term premiums must then be negative. That’s the only way to maintain the positive view of the economy and QE in an environment that doesn’t really fit the positive view of the economy and QE.

What is a negative term premium?

Like a negative swap spread, for instance, it is utter nonsense. But at least in the case of an interest rate swap, the nonsense is valuable (since it tells us there must be a grave imbalance in the marketplace itself). A negative term premium, by contrast, is nothing more than full-blown denial.

As you’ve probably heard, the US Treasury yield curve inverted a couple days ago. While that’s technically true, it’s not exactly true by what’s been omitted. A specific part of the yield curved inverted – the comparison of the 2-year note with the benchmark 10-year bond. Investors buying and holding (meaning not selling) the latter are accepting a little less in yield than those buying and holding the former.

For many people, this a clear recession signal – and, sadly, the only reason the public pays attention to the yield curve.

While its true the 2s10s just inverted, the yield curve has been inverted in other places for far longer – going back to the end of last year, in fact. It had been controversially flattening out for even longer that that – going back to the end of the year before last, in fact.

I write it was controversial only because central bankers and Economists refuse to budge on their Fisherian deconstruction. Janet Yellen just the other day said pay no attention to the yield curve inversion (2s10s), it’s artificial.

“The reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”

It’s all in the term premiums, they claim. It can’t possibly be either or both of those other two constituent pieces.

But why?

While there is no market indication or price for term premiums, there sure as hell are for inflation expectations and the market-priced future path for short-term interest rates. The first one is called TIPS, the second eurodollar futures. They are directly related to these core concepts.

I’m sure you can guess how those markets have been trading. In 2017 and early 2018 when Janet Yellen was supposed to be at her apex, she was instead fending off questions about the curve. At her final press conference as Chairman, in December 2017, she was asked about it:

“The yield curve has flattened some as we have raised short rates. It mainly—the flattening yield curve mainly reflects higher short-term rates…Well, right now the term premium is estimated to be quite low, close to zero, and that means that, structurally—and this can be true going forward—that the yield curve is likely to be flatter than it’s been in the past. And so it could more easily invert.”

If term premiums had been more positive than they were judged to be at that point, by her, then interest rates especially at the longer end of the curve would’ve gone up much more and instead of flattening it would’ve maintained its shape if not steepened (before flattening at some level nearer to a normal interest rate environment). But why did (does) she believe term premiums were (are) so low or even negative?

R-star.

Economists have so warped their view of the world that the only way for it to make any sense to them is for a flat and now inverted yield curve to be something other than a flat and inverted yield curve. Having to reverse engineer how QE and low interest rates were not total failures, and that the bond market isn’t actually completely disagreeing with the Fed on every salient point, pricing a very different set of circumstances, they have to resort to even more tortured rationalizations and denials.

It only begins with circular logic. Back to Yellen at that key moment in December 2017:

“So I think the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider. Now, I think it’s also important to realize that market participants are not expressing heightened concern about the decline of the term premium, and, when asked directly about the odds of recession, they see it as low, and I would concur with that judgment.”

Wait a minute; the fact that the yield curve was flattening so precipitously as it had been doing was the market expressing concern. But Yellen says it wasn’t concern because term premiums were the reason it was flattening in the first place. So, falling term premiums flattened the curve, and usually a flat curve is a warning but not in this case because the curve was flattened due to term premiums.

And since low or negative term premiums are the presumed consequence of a low R-star, nothing-to-see-here. But why the low R-star?

QE was supposed to have produced or at least have assured a full and complete recovery from the Great “Recession” and the somehow Global Financial Crisis. It didn’t. Not even Ben Bernanke would admit there has been a full and complete recovery. From economic growth to the labor participation problem, the economy on this side of 2008 is stunted by every single measure. The question is why.

Central bankers, as you would expect, refuse to believe it was because a monetary event, the GFC, was met with an ineffective monetary response (QE and ZIRP). The very fact there was a GFC in the first place is relevant (in the bond market as well as this discussion) in setting our expectations here.

The only way around that possibility is to claim that QE did the best it could have – that if the economy is different after 2008 it must be because of structural factors beyond the grasp of any policy anywhere. R-star means QE didn’t fail, it actually succeeded but because of retiring Baby Boomers, drug-addicted unemployable workers, and lazy Americans who refuse to go back to school and learn to code, the results don’t show up in the way Ben Bernanke had promised way back when.

Don’t blame the Fed; it’s your fault.

And the bond market is only on their side when they cast term premiums in this way.

Except, no. We have all sorts of market evidence, deep, liquid, and sophisticated markets for TIPS and eurodollar futures that expose term premiums for what they are – central bankers rationalizing their own delusions in order to avoid the only factor that explains all the facts including interest rate behavior.

They’ve got the monetary system all wrong.

While Janet Yellen was rewriting the flat yield curve in December 2017, the eurodollar futures curve was also flattening because it was saying the market didn’t expect the Fed to complete nearly as many rate hikes. Something would surely go wrong first.

In June 2018, the eurodollar futures curve inverted; that something was much closer. Well over a year ago, when everyone said there was no way it would happen, this market which prices the expected path of future interest rates correctly surmised way ahead of time there would be rate cuts instead.

For its assigned part, the TIPS market had never judged inflation as some deep threat no matter how much hysteria was unleashed over the unemployment rate. Since last May 29, expectations first had become more neutral before last November falling and then falling some more this year.

The flat curve was exactly what the flat curve had always been – a warning that the financial risks were substantial and could tip the balance from a reflationary economy struggling to break out back toward a deflationary one which is its true underlying baseline condition. It even had the added benefit of telling you exactly why (the interest rate fallacy).

The inverted curve is simply the market saying to Janet Yellen, I told you so but like 2007 you refused to listen.

Therefore, the reason that the yield on the three-year (or ten-year) is less than the yield on the two-year (or one-year) is because the market foresees a lot of bad things developing in the near term and, perhaps more importantly, the consequences of those developments lingering into the intermediate term and beyond. The kinds of negative factors that will lead to much less inflation and lower short-term interest rates. The same risks – now realized - that kept yields low and the curve flat when Yellen was deluding herself and the public about term premiums and R-star almost two years ago.

Because all this term premium stuff is total garbage, obvious nonsense, of course Janet Yellen this week hedged on the question of recession.

“I think the U.S. economy has enough strength to avoid that, but the odds have clearly risen and they’re higher than I’m frankly comfortable with.”

Way to stick to your guns, Janet.

Recapping the former Chair: she thinks the yield curve isn’t what it seems to be, it isn’t what it always was – but is also worried it might be. That’s the problem with being forced into looking at everything backward. No matter how much you try to convince yourself that R-stars and term premiums are meaningful and righteous assessments, you can’t ever shake that nagging feeling that the thing really is what it is.

Economists don’t understand bonds because they don’t want to understand bonds; the bond market has been the one constant throughout telling the world officials really have no idea what they are doing.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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