Posts Tagged ‘treasury bonds’

Ratingzzz

6 August 2011

For years I taught money and banking under the impression that U.S. Treasury bonds carried no rating at all. I thought they didn’t need to be rated and that the rating agencies agreed. I thought the fact that bondholders accepted lower interest rates on Treasuries than on any other bonds, even AAA-rated bonds of other entities, meant they regarded T-bonds as the least risky (and most liquid) bonds out there. A related issue is whether there’s any point in rating the debt of national governments whose finances are an open book, unlike those of corporations who open their books for the rating agencies but don’t have to for the public.

Standard & Poor’s downgrading last night of Treasuries from AAA to AA+ reminded me of all that. Do bondholders really need S&P, Moody’s, and Fitch to tell them whether T-bonds are safe? Anybody who follows the U.S. fiscal news  — e.g., anyone in the bond market — would have their own judgment on the matter. Call me cynical, but I find the timing of the announcement suspicious. First, it comes rather late, as it was clear five days ago that the Budget Control Act of 2011 was going to pass and what the substance of it would be. Second, it comes at the start of the weekend, two days before the markets reopen; that’s plenty of time for other news to come along and offset whatever effect S&P’s announcement has on the markets. My cynical hunch is that S&P is afraid the announcement will have no effect on the T-bond market, thereby underscoring their own credibility rating, which has been F ever since it came to light in 2008 that they’d been rubber stamping toxic bundles of subprime mortgages as AAA. I think their announcement is their way of gambling that if the T-bond market ever does go south, they can say they called it first. (Kind of like those ridiculous predictions every week on “The McLaughlin Group.”)

As usual, Krugman nails it. He acknowledges that the intransigence of Congressional Republicans makes any kind of meaningful long-term debt deal unlikely, but says:

‘On the other hand, it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?

‘Just to make it perfect, it turns out that S&P got the math wrong by $2 trillion, and after much discussion conceded the point — then went ahead with the downgrade.’

In passing the Budget Control Act, Washington lawmakers put deficit reduction ahead of job creation, against the wishes of the public, Keynesian economists, and even (apparently) the stock market. Yet it wasn’t enough for S&P, who say the way out of this hole is to dig even deeper. No, S&P, slashing spending and raising taxes in a depression doesn’t improve our financial health. Krugman again:

‘More than that, everything I’ve heard about S&P’s demands suggests that it’s talking nonsense about the US fiscal situation. The agency has suggested that the downgrade depended on the size of agreed deficit reduction over the next decade, with $4 trillion apparently the magic number. Yet US solvency depends hardly at all on what happens in the near or even medium term: an extra trillion in debt adds only a fraction of a percent of GDP to future interest costs, so a couple of trillion more or less barely signifies in the long term. What matters is the longer-term prospect, which in turn mainly depends on health care costs.

‘So what was S&P even talking about? Presumably they had some theory that restraint now is an indicator of the future — but there’s no good reason to believe that theory, and for sure S&P has no authority to make that kind of vague political judgment.

‘In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right.’

Ironically, the U.S. attained its AAA rating in 1941, just as we were heading into World War II and the (publicly held) national debt was about to explode, to about 140% of GDP, roughly double what it is now. S&P evidently took the long view then.

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Is inflation on target? (corrected)

5 August 2011

The new BLS unemployment numbers (9.1% unemployment rate, 16.1% comprehensive unemployment rate, 117,000 new jobs created) are the talk of the morning. I don’t have much to add to it, but I’ll echo the oft-made point that job growth needs to be twice as fast for the next several years for unemployment to fall to normal levels. I’ll also note that the numbers are a bit better than those of a year ago, but a bit worse than those of March, when unemployment was 8.8%. So although the numbers are better than expected, they’re still underwhelming and we still might be in a double-dip recession.

Instead I want to focus on the other big economic variable. Inflation has been so low over the past few years — in the range of 1-2% — that Ben Bernanke and others have seemed more worried about deflation than inflation. At the same time, some Fed critics have charged that the Fed’s actions to backstop dodgy financial asset markets and flood the banks with new reserves will lead to a massive inflation after the slump is over or a stagflation (stagnant economy with high inflation) even sooner. Some numbers to remember: Inflation has averaged 3% a year over the past century, and close to that over the past few decades. The Fed’s unofficial target for inflation is 2%. What do the markets expect for the years to come?

A good way to answer that question is to compare the well-reported interest rates on regular Treasury bonds with the interest rates on “TIPS” — Treasury Inflation-Protected Securities. The payments on a TIPS bond are adjusted for whatever inflation occurs over the bond’s lifespan.  The inflation adjustment is trickier than I’d originally thought — instead of simply adding the inflation rate to the interest rate that arose from the bond’s auction, the interest rate stays the same but the bond’s principal rises, and the interest payments are based on the original interest rate times the new principal. (Ex.: Imagine a 1-year, $1000-face-value TIPS bond that sells at par, i.e., for $1000 and therefore has an interest rate of 0%. If inflation is 3% over the next year, then the principal rises 3% to $1030. The interest is still $0, but the overall yield on the bond is 3% ($30/$1000). That’s a simplified example. It’s more complicated if the interest rate isn’t 0%.) Because the arithmetic can get complicated, it’s easier to look up the “breakeven” rate, which is the inflation rate implied by the different on TIPS and ordinary T-bonds.

(Add to that a conceptual complication: Because the TIPS bond is less risky, since it’s indexed for inflation, it should be in somewhat greater demand than the regular T-bond. So, other things equal, it should command a higher price and pay a lower interest rate. With that in mind, the difference between the interest rates on regular T-bonds and TIPS bonds is roughly the expected inflation rate plus an inflation-risk premium, which reflects people’s uncertainty about future inflation.)

Comparing the interest rates for 5-year bonds last week (when this was originally posted), the  T-bonds paid 1.12% and the TIPS paid -0.67%. The implied inflation rate (1.80%, if my spreadsheet math is correct) is actually very close to the difference in the interest rates on the two bonds (1.79%). Apparently the market is expecting the Fed to be just shy of its 2% target over the next 5 years.

Looking at the 10-year bonds, the T-bonds paid 2.47% and the TIPS paid 0.24%. The 2.03-percentage-point difference is again a close approximation of the breakeven rate; my spreadsheet math yields an expected inflation rate of 2.22%, or slightly over the Fed’s target. Together the two breakeven rates imply that the market is expecting inflation to average about 2.6% in years 6 through 10. These numbers provide no guide to where they think that inflation is going to come from (recovery? shortages of gas or food? QE5?), but the weakness in the stock market suggests they’re not expecting a recovery anytime soon. It may just be that their flight to safety has gone into overdrive, and TIPS are in exceptionally heavy demand because they are even less risky than regular T-bonds. So possibly they’re expecting inflation rates of about 1% through 2016 and 2% in 2016-2021, with the remainder being a risk premium.

In sum, the Fed does seem to be hitting its inflation target, more or less, but that’s about all. Bondholders appear willing to lock in near-zero or negative real returns over the next five or ten years, just so they can hold a safe asset. Which suggests they’re scared shitless.

Dead man’s curve?

3 August 2011

Scott Sumner’s blog The Money Illusion has two provocative posts today that argue that Federal Reserve policy is currently too tight, despite the near-zero fed funds rate, and cite as evidence the extremely low interest rates on 5-year Treasury notes. I’m going to grapple with his monetary policy argument at some later date (the gist of it seems to be that the Fed should target nominal GDP and therefore combat the current slump with much bigger increases in the money supply than we’ve had). For now I want to focus on those 5-year bond rate data, which are bad news indeed.

The most recent 5-year bond yield, as of yesterday, was 1.26%. That’s close to a historic low. What does it mean? The standard interpretation in a money and banking course is that interest rates on 5-year bonds are the average of current and expected future short-term bond rates over the next 5 years (since a close substitute for a 5-year bond is a series of short-term bonds held over the same span), with some allowance for people’s preference for short-term bonds as more liquid (you get your money back sooner) and less risky (you don’t have to worry about market interest rates shooting up after you’ve bought your bond and then being stuck with a subpar yield for a long time). So, the number suggests that people are expecting very low short-term bond yields over the next five years. Short-term interest rates are a function of two big things: the state of the economy (they’re lower in economic slumps) and the expected inflation rate (when inflation falls, lenders and bondholders will accept lower interest rates; and inflation also tends to be lower in economic slumps). And in the case of T-bonds, the interest rates reflect the jitters of worldwide investors — the more nervous investors are about stocks and corporate bonds, the more likely they  are to flee to the safety of Treasuries.

So, then, a near-record-low 5-year T-bond rate means investors are expecting (1) economic weakness for the next 5 years and/or (2) low inflation for the next 5 years and/or (3) investor anxiety for the next 5 years. I’d vote for all of the above. And (2) and (3) are common symptoms of (1).

To see just how low these recent 5-year Treasury yields are compared with those of the past nine years, see this Dynamic Yield Curve, which shows the interest rates on T-bonds of different maturities.  If you click Animate, yield curves from 2003-present flash by and you’ll see that that the norm for 5-year rates is about 3 to 5%. So the bond market apparently expects the economy to be way below average for the next five years. Even the 10-year bond rate was only 2.66% yesterday (it’s normally above 4%), so a ten-year depression is not only possible but maybe even probable, according to the market.

Taking their chances on the wall of debt

29 July 2011

This morning’s surprise news is that, after last night’s fiasco in which House Speaker John Boehner could not round up enough votes for his own deficit reduction plan, 10-year Treasury bond prices are not only not down, they’re actually up, by a good bit. Interest rates on Treasuries, which move in the opposite direction as T-bond prices, are down 10 basis points to 2.84% (as of 11:14 a.m.). What gives?

Well, for one, the bond market may not have been expecting much from Boehner. The media had already been saying that he’s a much-weakened House Speaker, after watching his failure to rein in his Tea Party faithless. And any House Republican plan would likely be dead on arrival in the Senate anyway.

Another possibility is that as it becomes more likely that the government bumps up against the current debt ceiling on Aug. 2, that counterintuitively, T-bonds might actually be seen as safer, as Chris Isidore writes in CNNMoney. Why? Because the single biggest actor on the U.S. economic stage, the federal government, would be officially dysfunctional, even more so than it is now. Today through Aug. 1, at least, the government can meet all of its financial obligations. If Aug. 2 is indeed D-Day, then on Aug. 2 the government becomes a deadbeat, at least to somebody. And quite likely, it would not be T-bondholders. This assumes that (1) the government would still be allowed to issue more debt in order to pay off its maturing debt and (2) the Treasury would prioritize the interest on that maturing debt above its other obligations. As notes on NPR this morning, most commentators seem to agree that it is in the national interest to not stiff any of our bondholders, as an actual default would surely cause interest rates to skyrocket. If Aug. 2 is the beginning of Treasury triage time, then the government would more likely stiff someone else, like government employees (please please start with members of Congress!) and government claimants who lack political clout (i.e., not seniors or the military). This creates a lot of chaos, as people don’t know when they’ll be paid, which makes them less likely to spend or repay money and creates pressure on credit markets. In sum, the market reaction may just be the usual “flight to safety” that occurs when markets think conditions are about to get worse and also more chaotic. This would be consistent with the beating that stocks have been taking lately.

It may also be that the bond market is reacting to other news, like the dreadful GDP figures that just came out today. Real GDP in the second quarter grew just 1.3% (worse than the consensus forecast of 1.8%), and first quarter growth was revised drastically downward to 0.4% (from 1.9%). These numbers are “growth recession” territory (where the economy grows but not fast enough to generate enough jobs to keep unemployment from rising), consistent with the rise in unemployment (from 9.0% to 9.2%) over the last few months. As with the debt-ceiling brinkmanship, these new signs of economic weakness are a plausible reason to pull money out of stocks and put it into Treasury bonds.

But why Treasury bonds, you ask, and not another safe haven? The simple answer seems to be that there are woefully few alternatives. As Isidore puts it:

‘U.S. Treasuries are such a massive market — about $9.8 trillion — that they dwarf the markets of other so-called “safe havens” such as gold, top-rated corporate debt or the bonds of other countries with AAA ratings.’

So worldwide investors still like their chances on the wall of debt that is U.S. Treasuries.

P.S. Richard Thompson’s duet partner here is not Linda Thompson, but Christine Collister.

Not shaken, not stirred

25 July 2011

So far, the Treasury bond market seems remarkably unconcerned about Washington politicians’ abject failure to reach an agreement on raising the debt ceiling. As of 3:20 pm Monday, after a weekend of dashed hopes for a bipartisan agreement for deficit reduction, the interest rate on 10-year T-bonds was 3.00%, up just 4 basis points from Friday’s close of 2.96%. I admit, I woke up expecting more of a negative reaction from the bond market. What gives?

From what I’ve read, there seem to be two factors at work here, of which the bond market is well aware:

(1) The debt ceiling drama has happened before, and those in the bond market expect Congress to raise the ceiling in time, just as they always have before (with the exception of 1979*). In all, Congress has raised the debt ceiling 74 times since 1962, including an average of once a year since 2001. Barry Ritholtz provides an excellent compendium of newsbites about past debt ceiling votes.

(2) Washington tends to go down to the wire on these deals, and this year “the wire” is Aug. 2, i.e., eight days away. Again, history suggests they’ll get a deal done this time, too.

* The 1979 episode has oddly disappeared down the memory hole, despite two months of hostage-taking over the current debt ceiling and despite the fact that the temporary default of 1979 — it lasted two weeks and was caused by a combination of Capitol Hill shenanigans and computer problems at the Treasury — caused Treasury interest rates to be an estimated 50 basis points higher for years, costing taxpayers billions in increased interest payments on the debt and slowing the economy. (Hat tips: Andrew Sullivan, Bruce Bartlett. The 50-basis-points estimate is from finance professors Terry Zivney & Dick Marcus.)

So is this summer’s repugnant, reckless, Republican posturing over this issue all that different from past obstruction by Democrats and Republicans over the necessary and obvious business of raising the debt limit so that the government can honor its commitments to creditors, employees, contractors, retirees, etc.? I haven’t seen anything this extreme since I started following politics, but then again that’s only been 30 years, and this time-wasting exercise that is the debt-ceiling vote has been around since 1917. (It probably served a purpose back then, as we were entering a world war.) If this time is different, the difference may be the simple fact that a great many Republicans (not just Michele Bachmann and the Tea Partiers but 53% of all Republicans, according to a Pew Research Center poll) think it will be no big deal if the debt limit is not raised by Aug. 2, or perhaps if it is not raised at all. Since President Obama clearly does and is unwilling to press for a clean vote to raise the debt limit with no strings attached, they’ve got him over a table.

shaken, not stirred

Raise the damn debt ceiling already

12 April 2011

As if the new agreement between the president and Congressional Republicans — to cut $38 billion in spending while the economy is still in a near-depression — weren’t bad enough, now the word is that the Republicans say they won’t vote to raise the debt ceiling, at least not without extracting several pounds of flesh first. Worse still, the overwhelming majority of the public opposes raising the debt ceiling.

I’ve blogged about this topic before. Not raising the debt ceiling would be like pushing the economy off a cliff. With a deficit of $1.5 trillion (and GDP of about $14 trillion), Congress would have to cut spending or raise taxes (or some combination thereof) by more than 10% of GDP. You don’t get that money back. That would be a depression of titanic proportions.  It would be ruinous under virtually any circumstances, but all the more so now, at a time of high unemployment. Herbert Hoover’s and FDR’s budget-balancing blunders during the Great Depression would be trivial by comparison. And Congress probably couldn’t come up with $1.5 trillion or anything close to that anyway. Normally we pay off our Treasury bonds as they come due by selling more bonds, which we would not be able to do anymore if the ceiling is kept constant. So we would default on all the maturing debt, and our new bonds would lose their AAA status, instantly and permanently, and we’d have to pay higher interest rates on our new bonds. With enough defaults our bonds would quickly be junk bonds, paying sky-high interest rates. This would add to the federal deficit and debt, possibly a lot.  So much for looking out for future generations.

If the Republicans pull the same game of brinkmanship that they did last week in nearly shutting down the government, by convincingly threatening to not to raise the debt ceiling and then raising it at the last minute, the bond market will still go oink (as one of my grad school professors used to say), and interest rates on Treasury bonds will still shoot up, meaning higher interest payments and a higher burden of paying them off. Bond investors hate uncertainty, and if default even looks possible, they will no longer regard Treasuries as riskless.

All of this opposition to raising the debt ceiling is a combination of cynicism, ignorance, and self-sabotage. We do have a long-term debt problem that needs to be addressed, but blowing up the economy is the most idiotic and counterproductive solution imaginable. Threatening to blow up the economy is not much better. As long as the economy is in a slump, the optimal amount of spending cuts is $0 (if continued stimulus is out of the question), not $1.5 trillion. And it would be even more optimal to have no more debt ceiling.

Printing money?

10 June 2009

Trivia question:  How much money has the Federal Reserve printed in its entire ninety-five-year history?

Answer:  $0.  The Bureau of Engraving and Printing, part of the federal government’s Department of the Treasury, prints all the money.  And none of those bills become “money” (i.e., part of the money supply, M1 or M2) until they’re held by the public anyway.

Am I being pedantic?  After all, those dollar bills are “Federal Reserve Notes” and are delivered to the twelve Federal Reserve Banks upon request.   I don’t think it’s pedantic, though, as there’s a world of difference between printing money and dropping it from a helicopter (as described in countless economics classrooms and which would be very inflationary) and how those bills actually do hit the street (generally not covered in econ classes, an omission that has always mystified me*, and which is not so inflationary).

Anyway, what brought on this post is the constant chatter in the media and the blogosphere about how the government or the Fed is printing money.   (Of course this chatter is most pronounced on the right.  The three minutes I heard of Limbaugh’s show this year were devoted to some witless sarcasm about we should all be allowed to print counterfeit money because the government is already doing it.  Har de har.)

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Please tell me that this was just a slip of the tongue

14 December 2008

As President-elect Barack Obama and Congress shape a stimulus package, the president-elect made a strange departure from his prepared remarks to a governors conference, telling them that despite his support of a fiscal stimulus, “We are not, as a nation, going to be able to just keep on printing money” (Washington Post, 2 Dec. 2008.  Not surprisingly, conspiracy-minded commenters on a Ron Paul bulletin board were all over this one).

Hello?  Does Obama believe we currently finance our deficits by printing money, as opposed to selling Treasury bonds?  I sincerely hope that this was just a garbled version of his usual, and reasonable, point that although we need a big fiscal stimulus now, we need to bring the national debt under control in the long term.   (Some, like David Stockman back in the 1980s, have sketched a worst-case scenario in which our national debt gets so out of control that eventually the government has to print money to pay its bills, thereby causing a hyperinflation.  Possibly Obama was alluding to those fears, but since they’ve been basically groundless all along in the U.S. case, he’d be better off not feeding those fears.)

My larger concern is that when President Obama’s brilliant economic advisers disagree with each other, as economists are known to do, will he be knowledgeable enough to make the right call for the right reason?

(modified from a 2 Dec. 2008 post)

UPDATE, 17 DEC.:  Listening to NPR’s Marketplace this morning, it occurred to me that Obama just might have been referring to the dramatic steps taken by the Federal Reserve this year, which are basically equivalent to creating money.   But his next sentence — “So at some point, we’re also going to have to make some long-term decisions in terms of fiscal responsibility” — implies he was talking not about monetary policy but fiscal policy.  The concern still stands.