Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.

Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.

But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.

Ultimately of course rates will have to go up. If something cannot last forever, it will not.

Big Brother meets Ben Bernanke

[We interrupt our regular schedule of abstract pontification to bring you this quick note on price action]

All summer long, asset markets boomed while the US economy (in my opinion) more or less stunk. Why? Because of central bank policy.

Then on Friday we had a strong payrolls number (just 11k jobs lost, much better than expected).

I think this makes the Fed on the margin more likely to hike interest rates.

Sure enough, asset markets have been going down since the number came out.

It's almost Orwellian: war is peace, good news is bad news, strong numbers are weak numbers.

But that's what happens when you let asset prices be determined (supported) by central banks instead of by economic fundamentals.

Anyway, I'll go out on a limb and say that last week was the high for 2009 and we'll sell off into 2010.

This move will be reinforced by year-end risk reduction. Also, for what it’s worth, most technical indicators look really exhausted.

I have sold [EM] stocks aggressively over the last 3 days and now have plenty of [dollar] cash. Let’s see how things play out.

[Clarifications in square brackets added on 17 Dec; also, note that I currently own no US stocks.]

Buyers' Strikes and the Debt Treadmill

Here’s what I wrote last week:

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:

There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projections.
...
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt ... [But] the Chinese keep grumbling that they have far too many Treasuries already.

And here’s progressive economist Paul Krugman:

Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful) ... This is truly amazing. It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days, even though you’re currently able to sell long-term bonds at an interest rate of less than 3.5%.

Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.

The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.

Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about¹.

They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.

It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.

But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead².

The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.

(Source: UBS, via FT Alphaville; more here)

Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.

But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.

Footnotes

# ¹Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.

Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.

# ²As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.

The Next Bubble: Are We There Yet?

My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.

Nonetheless there are certain indicators that suggest we may be entering bubble territory.

Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:

1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead¹. Central banks are also less independent than before². Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them³. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.

2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.

3. The momentum towards lower global trade barriers seems to have turned; there are ugly signs everywhere of growing protectionism, higher tariffs, and incipient trade wars.

4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States⁴.

5. The commodity supercycle is now in its bullish phase.

6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.

Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.

Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!

What’s going on here?

Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).

But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.

First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.

Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.

(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)

Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.

A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.

Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.

Footnotes

# ¹ We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.

# ² Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.

# ³ A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.

# ⁴ Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.

Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.

The Next Bubble: Positive Feedback

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length:

In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

But one doesn’t have to invoke irrationality to explain positive feedback. Positive feedback can arise quite naturally when rational traders encounter flawed institutional mechanisms, as my previous post makes clear. Short-term incentives, asymmetric outcomes, incomplete information and firm-wide pay structures could all lead to perfectly rational actors taking actions which lead to positive feedback and hence bubbles.

Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.

Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.

It is the third kind of feedback – reflexive feedback, wherein a rise in the price of an asset positively impacts the fundamentals underlying that asset – that drives the most extreme bubbles.

So, which kinds of feedback are at work in the bond market today? Well, for starters, I don’t think irrational feedback applies. There’s certainly no groundswell of investors clamoring to jump aboard the bond bandwagon, and I don’t expect this to change for some time yet (if at all).

As for rational feedback, there is certainly an element of it driving bond purchases by foreign central banks, pension fund managers and carry traders. But in my experience, rational feedback tends to be a reaction to (or symptom of) a bubble, not a precursor to it; at any rate it is not sufficient to inflate a bubble on its own.

Finally, let us consider reflexive feedback. This is the subtlest case of the three, and the most interesting. Is there a mechanism for reflexive feedback in the bond market today?

I believe so. It works like this:

The Fed lends money to banks at 0%, hoping that the banks will turn around and lend to businesses and consumers. But why should the banks do this? They'd much rather buy bonds at 4% and make the carry. Of course some amount of funds does in fact go to businesses and consumers, and some amount goes into riskier assets (this year, for example, these riskier assets have included commodities and emerging market stocks). But as a proportion of the whole, these amounts are minuscule.

Meanwhile the Treasury issues gigantic amounts of debt and that's where the bank money goes. And it creates a self-reinforcing dynamic: banks buy bonds and keep long rates low; the Fed sees low long rates as evidence that the market does not anticipate inflation, and so keeps short rates low; the Treasury sees strong demand for government paper and weak third-party lending and concludes that more issuance is both acceptable and required; and the cycle continues.

Note that it is precisely the fact of low overnight rates that makes buying long bonds attractive for banks. And it is precisely the fact of healthy demand for long bonds that encourages the Fed to keep overnight rates low. That’s positive feedback in its cleanest form.

Again, this is not (yet) proof either way that a bond bubble exists. It is merely suggestive evidence that a necessary condition – reflexive feedback – is in place for such a bubble to inflate. I will review some other pieces of suggestive evidence in my next post.

The Next Bubble: Fundamentals and Technicals

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.

Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.

So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:

1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war; reduced military spending; the peace dividend
3. The lowering of global trade barriers and tariffs
4. China’s entry into world commerce and its export of wage and retail disinflation
5. The bear leg of the commodity supercycle
6. Improvements in business technology, especially in inventory management¹

But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years²:

1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports.
2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory
3. Risk aversion in the aftermath of the crash
4. The dollar carry trade

Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.

But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.

Footnotes

# ¹Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"

# ²Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.

The Next Bubble: Disclaimer and Disclosure

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.

All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.