Wednesday, September 22, 2004

Monetary Policy: Why rates are REALLY rising

Bard Delong is a nice guy, but he sometimes is a bit dense. He wonders why the Federal Reserve is raising interest rates.

I have a hard time imagining a world next summer in which the Fed is sorry that it did not raise interest rates today. But I have an easy time imagining a world next summer in which the Fed is sorry that it did raise interest rates. So I'm having a hard time understanding their thinking.

Which is interesting because he answers his own question in a previous post, but he doesn't seem to connect the two issues.
The late Rudi Dornbusch said that the collapse of unsustainable currencies and other wrong-headed policies invariably took place in four stages:
    Enthusiastic investors and speculators chasing immediate short-term returns cause the anomaly to last for longer than economists expect.

    Puzzled by the failure of prices to return to fundamentals or of unsustainable policies to generate a crisis, highly-intelligent economists evolve theories explaining that *this* time it really isn't unsustainable.

    Fortified by these theories, yet more investors and speculators chasing short-term returns flood into the market, causing the anomaly to last for *much* *much* longer than economists had originally expected.

    The supply of greater fools comes to a sudden end; the crash comes; the crisis comes.

Now that the highly intelligent Catherine Mann of IIE has formally stated that the U.S. current account deficit is not *that* unsustainable, this episode of the U.S. dollar cycle has officially reached stage (2).

This is the inevitable conclusion of expanding systematic and structural accounts deficits. Ian Welsh at BOP summarizes this:
That's it. That's all. Sell goods, sell your country or sell your future.

To Brad's note I had this to say:
Debt finance I'm afraid. There have been several sticky points in auctions recently. The buyers are increasingly becoming speculaturs and foreign exchange intervention like the BOJ. In order to finance spending, interest rates have to go up in order to make Treasuries more attractive. If the Fed refused to do this, there could actually be a debt sale crisis.

While economic management has become the raison detre of much theory and speculation about Fed action, first and last they are in the business of selling paper. No paper get's sold, and nothing else happens. The Fed has built up incredible institutional market-moving power by being able to dictate the terms and environment that it markets its paper in- but in the end even it cannot through management techniques wish away the fundamental unsoundness of escalating deficit spending.

Many things have been written about the US debt, but the most obvious point is that someone else must be willing to buy it. If you were looking at US debt, would you consider it an attractive investment purchase? Would you like to bet against long term US inflation in this environment of energy price escalations?

If not, then it shouldn't be a wonder that the Fed is raising rates. It knows it will kill the economy Brad, but it's a simple matter of flogging goods at an outdoor market. The price of that paper must be what the market will bear, and the market is decidely not interested in a declining yeild environment as a purchase.

To which others such as Winslow responded:
Oldman you mix the Treasury with the Fed.

Even as short term rates (set by Fed) are increased, long-term rates (set by the "market") are falling.

But as Bento notes:
True, the oldman may have been speaking a little loosely, but I can't imagine Greenspan is indifferent to the financing of US debt. We had a big shortfall in 5-year note purchases by foreign banks a couple of weeks ago, which was made up by some masked man, who rode in out of nowhere and untied Polly from the tracks. Seems we've been skating close to crisis here.

To which Khariss noted:
It is very hard to see any real problem with demand at any recent Treasury auction. There was, in fact, a shift from indirect to direct bidding at the most recent 5-year auction, but it is anybody's guess what caused it. One prominent guess among Treasury traders is that an account that typically goes through dealers instead went through the Treasury's new and improved on-line TAPS system. If that's true, notes went pretty much to the same buyers as always, but the statistics reported after the auction showed a marked shift in the path the notes took.

Bid-to-cover ratios at recent auctions have been higher than average. Demand for Treasury paper is quite good.

But as Anne noted:

"Demand for Treasury paper is quite good."

Agreed. What puzzles me is whether a 4.04% 10 year Treasury Note should be comforting or worrying. Essentially we are still moving through the bull market in bonds that began in December 1981. The Vanguard Long Term Bond Index fund is up about 5.70% this year.

Which brings the oldman to his point. The oldman is not blind to the institutional difference between the Federal Reserve Banking system and the Treasury, but nonetheless the core fact is that the Federal Reserve has to act to keep the Treasury in business but has no leverage over Treasury. Therefore The Fed is always cleaning up after Treasury.

In this case, we can see a simple answer to these different POV's in this article on the markets:
Short-term bond prices fell after the Fed announcement, but longer-term bonds rose and yields fell slightly, with traders apparently reassured the Fed has inflation in check. Long-term bond prices have risen in recent weeks, while long-term rates have fallen.

The people objecting to the oldman's assertion are partly correct, but also partly wrong. They aren't thinking in long term time scales, and if you take the long view it explains perfectly the Federal Reserve's action. The Federal Reserve is acting to prop up Treasury paper being issued on the long end of Treasury bonds. The reason why is that the Federal Reserve knows that a financial crisis in America is not imminent, but that the long term - as in a decade or more - estimated balance sheet is deteriorating. Between trend energy price increases, continued capital flight, a lack of political will to reform the fiscal structure of the government, etc. there is a strong trend toward the rates drifting upwards. In order to counter this, the Federal Reserve has to make their paper more attractive, and leverage the short end against the long end. If they were to allow market momentum to create a pop in yeilds on the long end, it would undo their ability to control the short end.

A banker once told me that one of the most difficult things for most people to understand about bonds was that the yeild traded inversely to the price and the factor of time in both things. The same thing applies here.

All the above commentators are correct, but they don't see the big picture. For the Federal Reserve to maintain its institutional leverage it has to make sure there are no disruptions in Treasury market. The factor of time and the way that prices and yields tend to trade inversely means that sometimes it has to do counter-intuitive things. Such as raise interest rates now, in order to keep them from rising ten years from now.

Part of the success of the modern Federal Reserve management history has been to understand and work across time successfully to keep yeild bubbles from building up momentum. If you combine this with the increasingly tenuous buyership of short term debt, then you can understand perfectly why to preserve its institutional power the Federal Reserve must raise interest rates at least in the short term. The Federal Reserve is not the owner, issuer, or seller of the paper from the Treasury - but it is effectively the auctioneer. To maintain its institutional power to leverage interest rates, it has to ensure the basic liquidity of Treasury auction sales and secondary markets. It must also act across time to prevent momentum bubbles from erupting, as they often do in equity markets that aren't managed - like the stock market.

Hence why demand can be quite good while at the same time in trouble. The Fed does not create this demand, but it does manage it. From managing it, comes its power. But in order to manage it, sometimes it must take actions for no other reason than to continue its management. Hence the current move, which is based less on economic fundamentals in the US economy than the Fed looking for excuses in the economic picture to do what it needs to do to maintain its long term institutional influence over the market. This is the nature of a meta-credit agency.


At September 22, 2004 at 11:08 PM, Anonymous Anonymous said...


The Fed can only do so much. Some people argue that their raising rates will push many into poverty, and will slow economic activity. While that's technically (i.e., w.r.t. actual current economic & social mechanisms) correct, it is not the Fed who is at fault, but govt. fiscal & social policy, and as a corollary economic actors who are encouraged to pursue specific things by the legislature & executive, like emphasizing asset speculation over "real" investment, offshoring, etc. Holding the Fed accountable for the economy is like if your car's gas pipe has a leak, your mechanic advises you that instead of plugging the leak, you should just "push the pedal harder". And Greenspan is not the whole Fed.

A related question is, what is the smaller evil, tightening money (if raising rates does achieve that), or letting inflation run amok? In terms of aggregate income, would you prefer a 5% paycut and 5% increase in cost of living or a 5% raise and a 15% increase in expenses?

In actuality it is somewhat different. As you go down the income ladder, I figure the (effective) "paycut" as well as the effective cost-of-living increase rate both become larger, an there is little of a social safety net to ameliorate it.

What say you?

At September 23, 2004 at 9:48 AM, Anonymous Anonymous said...

Losing your job is an even bigger paycut.

Stirling has written about this bind extensively - right now all they can do is let inflationr rise and get pathetic job gains, or stop inflation and bleed jobs. The Fed can only move along a curve and that curve is determined by things they have little control over.


At September 23, 2004 at 2:15 PM, Anonymous Anonymous said...

'Prices and yields TEND to move inversely'? For someone with 'banker' friends and so much to write about, you don't know very much about bonds. I'm not even going to respond to the rest, you don't even pay attention. I don't even get what the price/yield relationship has to do with the big picture. The price/yield relationship is the most basic and fundamental fixed-income relationship. Not understanding it and talking about bonds is like not knowing your ABC's. Hope I didn't misspell anything? PS. What's up with your post on the 22nd? You don't care about what people think of you, but you spend god-knows how many words talking about some secret thing you're going to do to help Kerry, with no details. Why are we suppossed to care?

At September 23, 2004 at 3:46 PM, Blogger Oldman said...

Yes, price and yeilds "tend" to move inversely.

That is the theory. In practice, there are scenarios when it departs from this ideal curve. The simplest one to imagine is deflation:

"The worst scenario for a TIPS investor is deflation, which would harm both price and yield. As the CPI fell, interest payments on the bonds would decline because the fixed-coupon rate would be applied to a smaller principal amount."

That from the radical disestablishmentarian rag called Forbes:

You are living in a world of fictions, and as such will always seek excuses to not believe the obvious and true. Yes, prices and yeilds tend to trade inversely. However, non-market events can intrude on this ideal quite easily.

As for why let people know, if you noticed - this is my blog. I do not get paid for it. I do not accrue publicity for it. I produce all content free of charge - and any advertising besides what blogger provides. This is more or less an online interactive journal and virtual socialization forum.

You don't like it? Well, there are plenty of other blogs to read - it's up to you.

I think you've grown up in a consumerized and politically pandering world, where people pretend to cater to you in order to take you for a ride. I want and need nothing from you, and whatever I share I share freely without asking anything in return. Perhaps you are incapable of conceiving of simple honesty in communication without ulterior expedient motives, but what this is about - what I am about - is just telling it the way that I see it.

You don't have to agree. You are free to condemn me. Perhaps though the thought of someone not out to use or snow you will liberate you to express yourself as you truly are. If that were to occur, I would be happy.

If you want an ulterior motive, there it is. I want each and every person here to be 'all that they can be'. One step toward that, is simply not being afraid to express myself as who I truly am without being flashy about it. To simply acknowledge the truth, without seeking any gain from it, is an end and power unto itself worthy of pursuit for its own sake.

And if that sounds too idealistic to you to believe, then consider this. My ability to use perception and finding weak spots to tip events, stems entirely from the fanatical devotion to such a practice. First you learn how to see the truth, and then you can learn how to see how to act on it.

So power, the eternal human motive, amusingly can underwrite the search for truth. Knowledge is power, if you truly know rather than just thinking you know. Because you never truly learn something, until you do it. So if you need a cynical reason for all of this - because the disinterested search for truth increases my personal power and influence.

But I still need nothing from you personally nor would be interested if something was available. That is the liberation that comes from relying on knowledge, and not lies or deception, to build a power base. You can afford to be honest.

At September 23, 2004 at 3:46 PM, Blogger Oldman said...

This comment has been removed by a blog administrator.

At September 23, 2004 at 4:55 PM, Anonymous Anonymous said...

I'm a bond broker, by definition, price and yield move inversly - always. Yield is quoted as the price in most situations, therefore there is a direct and inverse relationship between the two that NEVER change. So much for your knowledge. If you'd like the formulas, they're in ANY basic fixed-income book.

At September 23, 2004 at 5:16 PM, Anonymous Anonymous said...

forgot, tips don't have a yield because the coupon is based off cpi. forbes is wrong, the correct terminolgy would be return. your interest portion of the bondholder's return can go down, which obviously means the price would go down. return is not the same thing as yield. floating-rate instruments don't have a yield to maturity, because it can't possibly be known. This whole thing is turning on word choice, which can be complicated in the bond world. If you want to think that yields and prices tend to be inverse, that's fine, but my contention is that that would include an incorrect use of the word yield, which, again, is inappropriate for floating-rate instruments. Regarding the rest, I'm glad you think for yourself. Keep it up, but your assumption that I'm some sort of stupid patsy is ridiculous, and based solely on my questioning of your motives of that missive. I'm just sorry I wasted 15 minutes for nothing- I don't get what the point is, you obviously want people to read it (otherwise get a diary). So what the hell is the point? And spare me the soliquoy about truth, blah, blah, blah.

At September 23, 2004 at 6:16 PM, Blogger Oldman said...

Thank you for the lesson on basics of the bond trade. It was interesting and a worthy addition. However I think you're getting lost in the mechanics, as sometimes specialists are wont to do. Obviously yeilds and prices cannot move inversely absolutely because that would mean that an infinitely small price would have an infinitely high yield. Since prices can decline to zero without yeilds becoming infinitely high, then reality clearly must deviate from the ideal at some point.

Obviously the "always" part about prices and yields trading inversely isn't really true. Otherwise bonds could not go into issuance or out of circulation- in order to set the initial price in the first place you propose a discontinuity of the inverse relationship. Which is the whole point - action by debt issuer that compromise the integrity of the bond either dramatically or gradually is undermined - can cause deviation from the inverse price-yeild relationship.

Hence the use of the word "tends" as a generalization. I respect your expertise as a specialist, but it does not exempt you from the basic laws of reality, logic, or mathematics or he observed behavior in the market of financial instruments. "Always" is an overgeneralization on your part, just as "tends" is an oversimplification on mine.

Monologues about truth aside, is not this dialogue presently worthy of being called a dialogue in search of the truth?

You disagreed and my reaction is not to shout you down but to bring forward knowledge to struggle with you in a search for truth. That is a beautiful thing, if for no other reason than by this opposing views can be non-trivially reconciled.

So you've had your say, and I've had mine, and I am pleased to think that anyone reading this exchange might learn from it profitably.

At September 24, 2004 at 9:28 AM, Anonymous Anonymous said...

regarding the truth part, agreed.

regarding bonds trading close to zero, it wouldn't happen unless the bond is trading flat (interest is not being paid), so price/yield is irrelevant, no bond is going to yield in the triple digits, even. that is also part of the reason below-investment grade bonds trade on a price basis instead of a yield (or spread) basis.

could you clarify the paragraph about the bond issuer, etc. I don't understand how any of that relates to the basic mathematical fact that when a fixed coupon security goes down in price, whether it's 1/8 or multiple points, the yield goes up, and yes, I still maintain that is always the case, no exceptions. Again, yield is considered price (that is one of the reasons bonds trade on a yield basis). Traders can use yield as a quoting mechanism precisely because of the exact relationship between yield and dollar price. The exception being the previously discussed floating-rate securities, which, again, yield is inappropriate anyway.

At September 24, 2004 at 5:28 PM, Anonymous Anonymous said...

What is the basic, bottom line problem here???

The answer is GOVERNMENT DEBT, pay OFF the government debt and most of your problems disapear!

The original ideal of government deficet debt came from John Keynees (sp). His argument went; governments should borrow in the bad times and PAY IT BACK in the good times!!!

My argument is, that any government that does not pay OFF it's national Debt within 5 years is incompetent and criminal! or Criminaly incompetent... or what ever...

The only logical way to do this is to CUT government spending. This inturn might create "good deflation". In turn this would lower our production cost, increase our exports, increase our jobs, and raise our standard of living. At the very least it would decrease the offshoring.

Jim Coomes

At September 26, 2004 at 1:53 AM, Blogger Oldman said...

It has to do with mathematical terminology. Inversely proportional does NOT mean that as one goes down, another goes up. It specifics a very specific set of mathematical function mappings. Namely that if something goes up, something else must go down - by an exact amount.

Since bonds deviate from this pattern all the time, to be exact in language one cannot say that price and yield trade inversely. The correct langauge therefore is that they 'tend' towards an inverse pattern of trading.

Hence tend is actually a more precise and accurate description of how bonds actually work, than using the term inversely by itself which would be sloppy an inaccurate. Whoever went off on me about being picky about the word 'tends' was in fact, grossly mistaken in both mathematical terminology and in describing actual bond trading.

Price and yeild do tend to move inversely, but not exactly inversely. As one goes up, the other does tend to go down - but not like a strict inverse mathematical relationship generally. Otherwise bonds couldn't crater without their yeilds popping to asymptotic values. Yeilds always level out, and so do prices - in the real world. There is a finite value that someone is willing to pay for that bond, or conversely to offer credibly to the market as a yeild.

The fact that these floating ceilings in market values of bonds and yeilds exist mean for certain that the trading relationship may tend to approximate an inverse relationship but departs from it as well.

Therefore 'tends'. This is picky language, but so was whoever's bizaare idea to pick on the word 'tends' itself to uphold as an example of the worthless of knowledge - because if someone was going to pick an example to attack that would have to be the WORST possibility in the entire post.

But then I think the agenda was just to criticize, rather than discuss a real point - but ironically it just displayed their own relative ignorance of the use of careful language.

At September 26, 2004 at 7:24 AM, Anonymous Anonymous said...

I'm not the original bond trader, but he's right. Current yield is a simple derived quantity defined as the mathematical ratio between current price and coupon yield. As a derived or analytical quantity, if the current price goes up, the current yield always goes down. If the current price goes down, the current yield always goes up. Everything else, including how initial prices are fixed at auction, how inflation affects real yields, trading fees, and hypothetical factors involved with exotic securities, is external and this is where secondary "tendencies" creep in to affect trading -profits- but we're not talking about trading profits. Trading -yields- always move in an inverse relationship to trading prices.

Does "tends" matter? Not in itself. People use language like this all the time to cover themselves. I wouldn't have brought it up. But clinging to the original vagary (and justifying it as "careful" language, which it is in fact not, since it -obscures- an exact analytic relationship) seems unproductive at best to careful or professional readers.

At September 26, 2004 at 11:44 AM, Blogger J Thomas said...

They're right, within their technical specialty. "Price" and "yield" are technical terms and they are defined with the mathematical inverse relation. It's a definition thing.

I don't know what term to use to describe what Oldman is talking about. Like, say it's a junk bond. Because there's some risk the price is low and the yield is high. Then bad news comes out and there's a larget chance of bankruptcy and default. The resale price goes lower and the yield goes higher. Then more bad news. Lower price and of course higher yield. In the extreme, maybe a bond that originally sold for $10,000 is selling for $1 and it's getting an astronomical yield. Would you buy it? Maybe you'll get $10,500 or more likely you'll lose your dollar. But the mathematical relation between price and yield is still exact.

I get the impression that Oldman is looking for another word besides "yield". Something like "yield adjusted for inflation" or something like that. The actual increase in value. I don't know whether it should be measured in terms of, say, how many loaves of bread would it buy afterward compared to before. Or whether it should be in terms of percentage of world GDP or world resources afterward versus before. But he clearly isn't talking about just the mathematical relationship that we all agree isn't the point.

So does anybody have an idea what to call the term he's looking for?

At September 27, 2004 at 10:56 AM, Anonymous Anonymous said...

The term 'real' is commonly used to talk about rates excluding the rate of inflation. For instance, the real fed funds target rate in now negative. 1.75 minus inflation. common inflation measures are cpi, ppi, and the gdp price deflator - the preferred measure of the fed (due out wednesday).

Conceptually, whether price/yield tends is irrevelant, I agree. But considering the broad conclusions of the original article, you would think basic mistakes such as this one and others in the article wouldn't be met with such stubborness. I particularly enjoyed the attacks on my intelligence and the lecture about observed behaviors in the marketplace. Considering I have spent many years of my life observing the bond market 50 hours a week, you'd think I know what I was talking about. That doesn't mean I know shit, lots of people have intelligent, varied and reasonable opinions about the Fed. It, however, makes any potential discussion regarding the broader points seem a waste of time when the response to corrections to the basic and obvious are met with stubborn lectures about truth and other esoteric bullshit.

At September 28, 2004 at 8:27 AM, Blogger J Thomas said...

OK, so Oldman might have been talking about real rates, or about something else. Maybe he'll say.

I agree it was not useful for him to argue with you wrongly about the terminology. But if we assume that he might have some point, wouldn't it be better to find out what the point is than to just argue that he's wrong about his wording? He's making a point that isn't limited to bonds. He could be coming in from some other discipline,and he might have the important things right without knowing fundamental terminology. Or he could be all wrong. Why not look at the argument?

I could imagine that when you criticise the wording instead of the argument, he might feel that you're trying to discredit him without actually facing his idea. When he tried to defend his wording it let you discredit him for bond traders who all know that basic meaning and would ignore anyone who doesn't know it. It might make him angry if he thinks you're smearing him without considering the merits.

But I don't care about that argument. Is there a way to rephrase what he's saying that makes it right? If he misunderstands so much that his theory can't be salvaged, but it inspires you to make something that works, I doubt he'd insist on the credit.

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