There were several things we didn’t get to discuss last night regarding the Conundrum discussion.
1. Demand and Supply issue
Since the 30 year was cancelled, its a simple matter of the supply/demand equation. With less 30 year’s around, the price gets bid up, and the yield lowers. So Bond managers look to the 10 year, yielding only moderately less 4.41 versus 4.07 — but a third of long a duration.
Why is it that everyone in America – from Businesses to each and every homeowner has refinanced their debt at half century low levels – except for America itself? Who ever decided to cancel the 30 year owes Uncle Sam a big apology.
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2. Deflation warning.
Now that we seem to have inflation licked, there’s still that nasty worry about Asia exporting Deflation to the U.S. That will likely be the next battle. Unless we want to ignorethe warning signs — wage pressure, ever decreasing prices for finished goods, coupled with weak demand — Deflation remains a genuine concern.
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3. Its good for China
China has developed the biggest appetite for US treasuries – and Why not? The balance of trade deficit gives them more cash than they know what to do with. Why not buy US Bonds, and keep rates low for finance-loving Chinese-goods purchasing US Consumers? Until they are so stuffed with dollars that they have no where else to put them, and then they can dump them on the open market. While we are dealing with that mess, China then invades Taiwan. You read it here first.
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4. Bond Market is foreseeing an economic slowdown in 2006
This is the ugliest component – the Bond market may be foretelling a slowdown into 2006. Watch the market slong enough, and you cannot help but notice that the bond markets are the “adult supervision;” Equities markets, on the other hand, are more akin to a hormone addled teenager.
I’d be interested in hearing any other factors keeping rates low. Post below, and I’ll excerpt the best ones here later.
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For the other side of the argument, see Richard Clarida’s WSJ OP-ED, Our Post-Bubble World.
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Great blog.
Asking as an ignorant investor, what practical effect of the Chinese selling their treasury debt on the open market have on the economy, the equity markets and the bond markets? What’s the risk here?
does the 4% 10 yr rate have to imply low inflation and economic slowdown. cant it be one of the goods that too much money is chasing? i think the Treasury market is seeing the effects of many leveraged bets coming unwound: long commodities, long currencies, long mortgages, long hedge funds, all short the US 10 yr which everone thot was going to decline in price. now the leveraged bet is being called and folks are covering their Treasury shrots
Tens have 1/3 the maturity of bonds. I’m not so sure they have 1/3 the duration.
[BR: Poor choice of words on my part]
Barry–
Another significant player in the “conundrum” which you may have already discussed is the Japanese Private Investor and the Yen Carry Trade.
Japanese are great savers (30% I think) and their own paper yields nothing, so they are incentivized to buy US Treasuries as long as they think the Yen will not depreciate too much against the dollar. For them, 4.0% is enough to take that risk.
This would help to explain one chart you have shown recently, which is the high (Rsq = .9) correlation between the Nikkei and the 10-Year Yield. The logic seems to be: when the Japanese stocks are providing good returns, the Japanese invest at home. When the Nikkei is going down, they buy US Treasuries.
The role of the private Japanese investor in the conundrum was cited in a research report by Gavekal which has been noted by John Mauldin and others. If you are interested I can send/post the article.
Alex
Barry,
Good points. However, I think you are missing the effect of a stronger $ has had on the bond market, specifically the impact on inflation. Forget about the myth of twin deficits and the chants of Chap 11 for the our entitlement system, the global currency market is a horse vs pony race. Q1 GDP is revised upwards while Eurozone growth forecasts are cut and Japan hasn’t beaten an economic data point since they introduced the Nintendo 64. The bottom in the $ in early March also coincided with a top in the commodity markets and the widest tick in the TIPS spread (the measure of CPI forecasts for the next 10 years). As inflation expectations have eased, 10 years have rallied and the yield currently sits just off the low point of its range (4.0% – 4.5%). Anticipation of convexity hedging also puts a bid under the market around these yields as the talk is that mortgage portfolio mangers will have to buy more 10years at 4.0% to hedge prepayment risk. With the Dec Fed Funds contract priced at 3.75%, do you think Greenspan will feel comfortable retiring to Pismo Beach when the “conundrum” took a turn for the worse in Albuquerque?
Stronger dollar? Thats a 4 or 5 month phenomenon at most — We’ve been in a tightening cycle for a year. It hardly explains it.
As to whether the “The bottom in the $”, its still too early to tell . . .
Barry.
You have to sell the $ in the context of buying another currency. On which pony are you placing your wager? Should we buy the Euro with continuous lowered growth forecasts (cut du jour is Italy), German unemployment at a post WW2 high, and the refusal of the illiberal, anti-business French to sign the EU Constitution?
The Fed has been hiking rates for a year and the slowing growth in the money supply is showing up in the strength of the $. The rally will continue, in my contrarian opinion, because Gates and Buffett forgot they were betting against the perpetual trump card, the almighty greenback.
I try to know what I don’t know, and I know I don’t understand this bond market. Though there are all sorts of clever or facile explanations for the levels of long term interest rates, I simply find them ominous while not understanding why.
Ed Hyman, I find, shares my feeling and Ed knows the bond market.
Bond sentiment is, or at least was, incredibly bearish. Pundits had already sold and there was nothing left but buyers. Don’t you just love these more buyers than sellers arguments! This pushed bonds higher and yields lower. Now it appears that many are throwing in the towel and accepting the rise in bonds (capitulation?). This is the start of sentiment turning and could be the start of a top in bonds and bottom in rates. There is a whole lot of support around 4%. As far as the assessment that bonds are more worried about weak economic growth than inflation, the strong stock market presents a problem. Except for a normal correction from Jan-May in the Nasdaq and Mar-May in the S&P 500, stocks have been strong since August. Cheers and beers!
i might have missed it, but this discussion is not complete without reviewing the recent ramblings of Mr Gross and Mr McCulley over at Pimco. in a nutshell, they see a rational bond market. to wit (poorly paraphrasing): if this is all the inflation we can muster after several years of huge imbalances, fiscal and monetary stimulus, etc., then why should the yield curve go on a tear?! right or wrong the two make a very thought provoking (contrarian??) case for a low yield environment for years to come.
jw
http://www.pimco.com/TopNav/Home/Default.htm
Doesn’t somebody work at Pimco who was forecasting DOW 5000? I mean, does anybody take that seriously?
One good number on the core CPI does not mean that inflation is licked.
Interestingly, copper and aluminum prices seem to be bottoming over the past week — they tend to lead oil, and if growth is not as slow as it looked a month ago this could just be a correction in the oil market.
With imports roughly 150% of imports for the US to grow its way into a current account defict of only 2%-3% of GDP exports would have to grow at roughly double the growth rate of imports. The more likely scenario to correct the CA deficit is a recession induced drop in imports. Clardia is too optimistic.
Bond Market is foreseeing a significant (global) economic slowdown in less than 24 months.
The apparent ‘conundrum’ is simply the result of informed agents trading a large amount with an actual state of the world different from the one with the strong belief.
http://econ.bu.edu/chamley/IFFM.pdf
A key assumption in using Bayes theorem of subjective probability to map future probabilities is that participants are assumed to be risk-adverse. Read bondholder. Or as previously stated “ the bond markets are the “adult supervision;” Equities markets, on the other hand, are more akin to a hormone addled teenager.” Equity market participants are more apt to be risk-neutral or perhaps even risk-SEEKERS as maximizers of expected value. Traders that are risk-neutral price takers with heterogeneous belief, the price of a contract in a prediction market reveals NOTHING about the dispersion of traders’ beliefs and partially identifies the central tendency of beliefs”
http://www.faculty.econ.northwestern.edu/faculty/manski/prediction_markets.pdf
Its good for China
While we are dealing with that mess, China then invades Taiwan. You read it here first.
Actually I FIRST read this version of a WWIII sparked by deliberate economic warfare initiated by China on one of those Perma-Bear/Gold pumping sites about a year ago. The scenario has gain popularity since the publishing of Unrestricted warfare
Barry, they keep spooking the herd into bonds, Official announcement of 30 year reintro and Chinese RMB 5% unpeg will re align the yield curve, and preempt an inversion.
Holders of current 10 year paper will be clubbed like baby harp seals as their paper will drop like Paris Hiltons lingerie, i.e. really fast and easy….the silence of the bond lambs comes sometime in August, get a ticket now.
http://naybob.blogspot.com/2005/05/yield-curve-inversion-iii.html
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