Bonds are Most Certainly NOT in a Bubble

Are bubbles flying everywhere?As soon as anything rises in value these days, shortly thereafter comes the bubble talk.  It doesn’t even take long.  Take Netflix, for example.  The company has been one of the top performing stocks since markets bottomed in March 2009, yet solely because it has gone up in value so fast, people cannot help but call it a bubble or some form of hollow company a la Crocs.  Anything overpriced is not just overpriced, it must be a bubble.  This type of “black or white” mentality leads to very confused and muddled discussions on real, consequential events.  Lately all the rage has been the discussion of this so-called “bond bubble” and I feel compelled to add my two cents.

Bonds are most certainly NOT in a bubble at this point.  The key driver behind the move towards lower yields is the repricing of long-term growth expectations in the economy.  For the longest time Fed Fund Futures had anticipated the beginning of rate hikes to be within a quarter to half a year away from inevitable.  More recently however, the Fed Fund Futures started accepting the fact that “extended period” does in fact mean quite a while.  Only now are bond yields truly dropping in order to reflect the fact that an “extended period” of low interest rates and low growth is our reality. Pragmatic Capitalist provides a nice little summation of this phenomenon:

When it comes to this whole debate the most important factor is the mere reality of our economic plight.  As we all know by now, we are currently confronted with the threat of deflation, 9.5% unemployment, 74.8% capacity utilization, falling home prices, durable goods orders that are more than 20% from their peak levels, rising unemployment claims, equity prices that are 30% from their peak and high historical private sector debt levels.  When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad.  Perhaps not the best bet in the world, but irrational?  Certainly not.  As Vanguard says, when compared to the long-term growth potential of equities bonds currently look like a fairly good hedge.

People have money that they need to allocate one way or another. How exactly to allocate that capital towards cash, equities, or bonds is a very tricky question at the moment.  In the quest for yield, people will take the safest, most liquid alternative.  A year ago, Paul Krugman penned a “wonky” little blurb relating the liquidity preference and growth expectations to long-term interest rates:

So what determines the level of GDP, and hence also ties down the interest rate? The answer is that you need to add “liquidity preference”, the supply and demand for money. In the modern world, we often take a shortcut and just assume that the central bank adjusts the money supply so as to achieve a target interest rate….

….Right now the interest rate that the Fed can choose is essentially zero, but that’s not enough to achieve full employment….the interest rate the Fed would like to have is negative….the Fed’s own economists estimate the desired Fed funds rate at -5 percent….

In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. But the fact remains that our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.

Professor Krugman here is pointing out the fact that in a deflationary environment, where the demand for cash (i.e. savings) exceeds the rate of increase in the money supply, government borrowing must increase in order to close the gap between supply and demand with regard to money itself.  As the government increases its own debt burden, that affords the private sector the opportunity to save more on its own without leading to a drop-off in aggregate demand, and in turn, the national price level.

At the time, many insisted that contrary to what Professor Krugman was arguing, government borrowing would “crowd out” private sector borrowing, thus driving up interest rates in the private sector and triggering a hyperinflationary spiral.  Sure enough, over the past year, rates have continued to decline on both Treasuries and private sector debt (take a look at corporate debt, Freddie and Fannie debt, etc) and inflation remains nowhere to be seen.  With the recent talk of “bubble” in Treasury markets, Professor Krugman revisited his observation about the liquidity preference:

The view…back then, was that government deficits would drive up interest rates, choking off recovery. I and others argued that this was bad macroeconomics: interest rates would rise if and only if recovery took place. More specifically, short-term rates would stay near zero as long as the economy was deeply depressed; long-term rates would depend on expectations about the future of short rates, and hence on prospects for recovery.

So the key point is not the fact that rates are now considerably lower than they were when that debate took place; it’s the fact that rates have fluctuated very much with optimism about recovery, never mind the deficits.

In fact, if you had a naive loanable funds view, you’d expect the recent downgrading of expectations to drive rates up, not down — after all, a weaker economy means bigger deficits. But the opposite has, in fact, been happening.

And who exactly is “buying” the government debt?  Hyman Minsky explained one component of the demand for Treasuries in liquidity crisis in “Stabilizing the Unstable Economy”:

The volume of bank holdings of eligible paper may decrease because of a decline in borrowing needs of business, as happened in the great contraction of 1929-33.  A similar contraction cannot take place in a world with Big Government and the large deficits that occur in a downturn.  The deficit means the financial markets have to absorb Treasury securities—as private debt decreases banks can keep fully invested by acquiring Treasury debt.  Once banks acquire Treasury debt the Treasury-bill market is an effective position-making market.  When banks are acquiring Treasury debt and the Federal Reserve wishes reserves to grow rapidly, it can augment the reserve base by purchasing Treasury bills from the open market.

In our present crisis, the demand for Treasuries that arise from position-making in banks results in the hoarding of excess reserves.  In order to effectively increase the velocity of money during such a shock (and to trigger growth/inflation), the Federal reserve can start purchasing Treasuries on the open market.  The accumulation of Treasuries with excess bank reserves does actually serve an effective purpose for position-taking lending institutions by helping to sure up bank balance sheets.  Let us not forget that this entire crisis started with an over-levered housing and financial sector.  It was the deleveraging of the financial sector that triggered a wave of panic across the broader economy, and it will be the rejuvenation of the sector that leads us out of this mess.

Many might ask, isn’t China, and to a lesser extent Japan, the most important purchaser of Treasuries?  Could they not just pull their bid thus sending yields skyward and forcing the government’s hand?  I’ll let Pragmatic Capitalist carry the argument from here:

The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system.  So, when the government auctions bonds they are merely targeting reserves in the system.  This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here).   Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves.  The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory).  What is not occurring is some sort of funding mechanism.  The Fed could care less if the auctions are 2X, 3X or 4X oversubscribed.  They don’t get extra money when this occurs.  They don’t get a gold coin that can then be spent.  So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.

Ultimately, for a bubble to actually be a bubble there must be some emotive level of enthusiasm that drives prices skyward, subsequently followed by an emotive collapse.  Clearly there is little enthusiasm over US government debt.  It is not as if people are clamoring in with the expectation of obscene returns.  Far from it.  In order for bond yields to begin rising in price, we need some more tangible evidence of sustainable, broad-based economic recovery.  It should come as no surprise that those who assert the “bond bubble” argument are the very same who have consistently argued that Quantitative Easing and stimulus would inevitably result in Weimar-style hyperinflation.  As long as the liquidity preference remains high and growth low, interest rates will continue to remain low for an “extended period” and inflation will be subdued.  How long a period of time is an “extended” one?  That remains an unknown, however, we should all hope that it comes sooner rather than later.  Rates rising would be a good sign in our present economic state!