“Yields on US government debt, which move inversely to prices, have surged during May and peaked this week, leaving holders nursing their worst monthly loss since December 2010. The immediate cause was concern that the Federal Reserve would soon start to “taper” its open-ended bond purchases – with far-reaching consequences for US debt markets and perhaps signalling a turning point in the 30-year Treasury bull market.” --Financial Times, 31 May 13
Sometimes I think that I’m living in my own separate universe. Here is what I believe to be true: 1. The Fed has, for the first time in its history, adopted an explicit employment target. 2. The policy tool being utilized to achieve this target is the expansion of the monetary base (the Fed’s balance sheet) in order to expand the money supply (M2) in order to stimulate NGDP and business activity (which determines employment growth). 3. One way to express what the Fed is doing is that, because it cannot lower the nominal funds rate, it must reduce the real funds rate by raising inflation expectations from their current historically low levels. 4. Raising inflation expectations (which will require higher actual inflation, given the Fed’s low credibility) will raise bond yields, and rising bond yields are therefore an important measure of policy success. 5. If the Fed decides to prematurely end or to reverse QE, inflation expectations will not be raised, policy will lose its stimulative effect, and NGDP and employment growth will be lower. Bond prices will remain low.
The conventional wisdom in the financial media today is that QE, by buying Treasury bonds, “artificially” riased their prices. The current wisdom is that ending QE would eliminate this bond price-support system, and bond yields would rise to their “normal” pre-Crash levels. Talk of ending QE is said to be bearish for bonds, which is 100% wrong.
Wouldn’t be wonderful if inflation-targeting had the by product of lower bond yields? The more inflation that we had, the lower yields would go. Even though prices would be rising at, say, a 4% rate, investors would only demand a 10-year bond yield of 1.5%. We could then pay off the national debt by reducing its real value.
But the world doesn’t work that way. Bondholders demand a real yield, and react negatively to the fear of higher inflation. When the Fed was creating double-digit inflation in the late seventies, bond yields were also in the double digits; there was no free lunch then.
It is said that the Fed has been creating “artificial demand” for bonds, driving their prices above where the market would otherwise have them. But the Fed, despite its “massive” purchases, only owns a small proportion of marketable long-term government securities. The price of bonds is still set by the market, not the Fed. Rates are low because the market hasn’t fully bought the story that QE will produce “normal” inflation in the future, perhaps because inflation is currently 50% below target.
Project Syndicate is returning to Climate Week NYC with an even more expansive program. Join us live on September 22 as we welcome speakers from around the world at our studio in Manhattan to address critical dimensions of the climate debate.
Register Now
My interpretation of the recent bond sell-off is that the market is beginning to see the glimmerings of higher growth sometime in the future, which would lead to higher short and long-term interest rates as the current “extraordinary accommodation” is withdrawn. In other words, QE3 has begun to work its magic, and as it does, bond yields should slowly rise to normal levels. This is consistent with rising stock prices, reflecting expected earnings growth, despite rising interest rates. As stocks go up and bonds go down, the equity risk premium should decline from its current historic highs.
There is a possible scenario in which inflation and growth resume their pre-Crash levels, the funds rate rises, and bond prices fall substantially. The size of the potential loss involved in a resumption of 3-4% bond yields is very substantial. Somebody out there would be clobbered, and there would be considerable financial turmoil. The key question is how big and how leveraged the carry trade is today, and who is doing it to excess.
To have unlimited access to our content including in-depth commentaries, book reviews, exclusive interviews, PS OnPoint and PS The Big Picture, please subscribe
Kishore Mahbubani
offers advice to Western diplomats attempting to engage with Asia, identifies risks to the region’s stability, highlights Singapore’s lessons for developing-country leaders, and more.
The implications of the deepening Sino-American rift are far-reaching, because several of the world’s most pressing economic problems can be solved only with contributions from both countries. And, to address global challenges, active cooperation between the two economic powers is indispensable.
hopes that political will on both sides catches up with the opporunities for cooperation that now exist.
If the new "industrial strategy" is offering ideas for better public governance, it is useful. But it becomes positively dangerous when it turns to the private sector, where state interventions inevitably undermine competition, disrupt price signals, and dampen the motivation to innovate.
sees little reason to support the case for renewed government interventions in the private sector.
Log in/Register
Please log in or register to continue. Registration is free and requires only your email address.
“Yields on US government debt, which move inversely to prices, have surged during May and peaked this week, leaving holders nursing their worst monthly loss since December 2010. The immediate cause was concern that the Federal Reserve would soon start to “taper” its open-ended bond purchases – with far-reaching consequences for US debt markets and perhaps signalling a turning point in the 30-year Treasury bull market.”
--Financial Times, 31 May 13
Sometimes I think that I’m living in my own separate universe. Here is what I believe to be true:
1. The Fed has, for the first time in its history, adopted an explicit employment target.
2. The policy tool being utilized to achieve this target is the expansion of the monetary base (the Fed’s balance sheet) in order to expand the money supply (M2) in order to stimulate NGDP and business activity (which determines employment growth).
3. One way to express what the Fed is doing is that, because it cannot lower the nominal funds rate, it must reduce the real funds rate by raising inflation expectations from their current historically low levels.
4. Raising inflation expectations (which will require higher actual inflation, given the Fed’s low credibility) will raise bond yields, and rising bond yields are therefore an important measure of policy success.
5. If the Fed decides to prematurely end or to reverse QE, inflation expectations will not be raised, policy will lose its stimulative effect, and NGDP and employment growth will be lower. Bond prices will remain low.
The conventional wisdom in the financial media today is that QE, by buying Treasury bonds, “artificially” riased their prices. The current wisdom is that ending QE would eliminate this bond price-support system, and bond yields would rise to their “normal” pre-Crash levels. Talk of ending QE is said to be bearish for bonds, which is 100% wrong.
Wouldn’t be wonderful if inflation-targeting had the by product of lower bond yields? The more inflation that we had, the lower yields would go. Even though prices would be rising at, say, a 4% rate, investors would only demand a 10-year bond yield of 1.5%. We could then pay off the national debt by reducing its real value.
But the world doesn’t work that way. Bondholders demand a real yield, and react negatively to the fear of higher inflation. When the Fed was creating double-digit inflation in the late seventies, bond yields were also in the double digits; there was no free lunch then.
It is said that the Fed has been creating “artificial demand” for bonds, driving their prices above where the market would otherwise have them. But the Fed, despite its “massive” purchases, only owns a small proportion of marketable long-term government securities. The price of bonds is still set by the market, not the Fed. Rates are low because the market hasn’t fully bought the story that QE will produce “normal” inflation in the future, perhaps because inflation is currently 50% below target.
PS Events: Climate Week NYC 2024
Project Syndicate is returning to Climate Week NYC with an even more expansive program. Join us live on September 22 as we welcome speakers from around the world at our studio in Manhattan to address critical dimensions of the climate debate.
Register Now
My interpretation of the recent bond sell-off is that the market is beginning to see the glimmerings of higher growth sometime in the future, which would lead to higher short and long-term interest rates as the current “extraordinary accommodation” is withdrawn. In other words, QE3 has begun to work its magic, and as it does, bond yields should slowly rise to normal levels. This is consistent with rising stock prices, reflecting expected earnings growth, despite rising interest rates. As stocks go up and bonds go down, the equity risk premium should decline from its current historic highs.
There is a possible scenario in which inflation and growth resume their pre-Crash levels, the funds rate rises, and bond prices fall substantially. The size of the potential loss involved in a resumption of 3-4% bond yields is very substantial. Somebody out there would be clobbered, and there would be considerable financial turmoil. The key question is how big and how leveraged the carry trade is today, and who is doing it to excess.