Bond Carnage, Muddled Inflation Thinking, and Fed Options

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The Fed has a mess on its hands.

Yields on ten and thirty year Treasuries have shot up in the last few days as investors have become fixated on burgeoning Treasury supply in coming months and years. and, as belief in the “green shoots” story is rising, a shift to riskier assets. In addition, while the Chinese are still buying Treasuries (that is, they are still pegging their currency, determined to hold on to exports), they have shifted to the shorter end of the yield curve (and their past harrumphing about the dollar and Uncle Sam not stiffing them is probably on a delayed basis weighing on nervous investors). The yield curve is the steepest it has ever been.

The dealer community is also apparently very long Treasury bonds, so the losses they are taking now will be an offset to the “banks are earning their way out of this mess” picture.

The move up in yields isn’t simply a problem for companies that might have wanted to raise longer-term funding in the newly optimistic environment; it’s a huge spanner in the works for the Fed’s efforts to keep mortgage rates artificially low. Recall that while the Fed has been intervening in the markets, it has gone to great lengths to stress that it not doing quantitative easing, but influencing spreads. But with the long bond at 4.65%,, it can’t keep yields on mortgages as low as it wants them to be (not much north of 5%).

I had trouble with the logic of manipulating mortgage rates. Last week, in Washington, I mentioned that this keeping mortgages cheap would end in tears. What happens when the Fed succeeds in creating real inflation? A real market yield for mortgages will be, say, 6.5%, if not higher. And who will eat the losses on the 5% ish mortgages that are now under water? Hhhm, banks, pension funds, and insurance companies, who happen to be the same people who somehow cannot be permitted to take losses on bank bonds that would result from realistic pricing of bank assets.

Mortgage investors seem to have woken up to their risks. As :

One trader in a note reports that conventional wisdom held that FNMA 4s would not trade appreciably below dollar price 99-16. That issue as of his writing was trading at 97-23 and he is comparing the carnage to the MBS dustup of 2003.

There has been massive selling of mortgages by an eclectic group of clients. In the early stages of this game servicers and originators led the charge. Today real portfolios joined in the selling to make for the ugly scenario we have today.

Swaps spreads are still being crushed. Two year spreads are 4 1/4 basis points wider at 43 3/4. Five year spreads are 4 1/2 basis points wider at 53 1/2. Ten year spreads are 11 1/2 basis points wider at 28 1/2. Thirty year spreads are 13 basis points wider at NEGATIVE 16 1/2.

Suppeing mortgage yields was an inefficient way to rescue housing (a lot of people refinanced who were not in financial duress), but part of the rationale was that lowering mortgage payments even for them gave them more discretionary income, hence more ability to consume, and hence was stimulative. Not that I though rescuing housing was a good idea. Housing got out of line with incomes and rentals, That means housing prices have to fall; the trick is to figure out how to restructure the debt, not how to reflate an asset bubble.

Curiously, the Fed has not announced formal inflation targets. Many Fedwatchers seem to assume the implicit target is something responsible, say 2-3%, but many other commentators have argued that the Fed needs to create much higher inflation to depreciate the value of all the debt weighing down on the economy. That implies at least a 6-7% level (but having lived through that sort of inflation, 7% or higher starts to wreak havoc with financial reporting, since the difference in the rate of inflation of various line items is not consistent and makes divining real performance a difficult. You effectively get a performance opacity discount added to the normal equity risk premium).

But would that really be productive? Not in a setting of overburdened consumes with no wage bargaining power. We’ve been on that theme, and Marshall Auerback concurs:

The more I think about it, the more it seems to me the mainstream academic economic emphasis on creating inflation to fight debt deflation is somewhat muddled. The point is to relieve the debt service burden. Ideally, you then want the following: 

1. Lower nominal private interest rates that allow debt refinancing for those still solvent.

2. Higher nominal incomes for debtor households.

3. If insolvency is a large enough issue, either higher nominal asset prices to reduce bankruptcy, or a clear method of debt restructuring.

1 & 2 get you part way there anyway with lower discount rate, higher expected future cash flows.Not obvious to me how a 5-6% consumer price inflation would accomplish any of these three. How is gas at $4.00 a gallon, import prices up 10-5% y/y going to help indebted households? How are higher energy and metal and ag prices going to help businesses that use these as inputs make more profits, higher more people, and pay higher wages? Something seems really off in the mainstream prescription. I get that conceptually higher inflation erodes the real debt burden, but the “inflation” has to be of the sort that increases household money incomes. Labor surely does not have the bargaining power to forces wages up with prices in this environment. Real wages would be likely to erode. That cannot be good for debt service.

Back to the immediate question: what does this mean the Fed will do?

Despite the brave “helicopter Ben” talk, and the criticism Bernanke has made of Japan not pursuing quantitative easing aggressively enough (the Japanese beg to differ on this issue, they think not cleaning up the banks early on was their big problem). the Fed has gone to some length to claim that what it is doing is not QE but intervening to make credit more available in target markets. Indeed, its March announcement that it was going to buy up to $300 billion of Treasuries over six months, rather than a target, seemed even at the time a bit peculiar. That level wasn’t enough to make much of a dent in a mushrooming Treasury calendar, and announcing a fixed amount and a timetable actually tied its hands. The surprise announcement (it had been expected earlier, so investors had sort of given up and were caught off guard) worked for a while, but the content of the plan reduced the surprise element via its specificity (so investors take note: getting the transparency you want may not always be good for you).

Fedwatchers have said the Fed does not intend to change its posture at its June or July meeting. But the Fed’s pattern has been to be slow to act and then overreact. But would real QE work? My German client reminds me that the Fed has unlimited firepower and in the German hyperinflation, bunds were the last asset to break down. But here, if the Fed were to step up purchases systematically, it could very well wind up owning the market. How many investors would decide to sell into its bid? So QE would indeed create inflation, but might not control bond yields as much as the Fed hopes unless it is willing to buy whatever it takes to hold a given interest rate. The Fed does not appear willing to do that (or more accurately, to risk that it might balloon its balance sheet to a monstrous level to accomplish that, particularly now that the conventional wisdom is that the economy is getting better).

The irony is that this may wind up being a replay of 1936, when the economy started looking better and the government, worried about deficits, tried cutting spending and plunged the economy back into its morass. But with tax revenues and programs already passed, Team Obama couldn’t trim the fiscal sails even if it wanted to. The brave talk about reducing the deficit down the road does nothing for the Treasury supply hitting this year.

Now the Fed may get a mini-reprieve. If Thursday’s 7 year auction (a weird maturity), goes well, the market may stabilize and recover a tad. There are some other possible short term ways out, but they require cooperation.

The Japanese and Chinese do not want to see the dollar fall. Europe was not much in the way of a net importer even when the economy was more robust, and its outlook near term is worse than that of the US. If the dollar weakens, it means lower import demand at a minimum, and it could portend worse: a reversal of the seeming recovery (we never bought the “growth by 3Q story, but let’s stick with party line for now), which in combination with a weaker dollar could put trade back on the ropes, and a disorderly fall in the dollar could produce real upheaval. The Japanese yen is much higher than the authorities want it, and they have already threatened intervention. That talk drove it down to nearly 100 to the dollar, but it went back to the 94-96 range. They’d much rather have it at 105-110.

And both the Japanese and Chinese are likely to still be holding a lot of longer maturity Treasury debt (you can’t turn a supertanker quickly), so they are taking big time losses on any holdings. And even if they were to buy on the short end to keep their currencies down but the long end goes haywire and the US economy goes seriously in reverse, it’s a Pyrrhic victory. Yes, their currency will be favorably priced, but no one here will be buying much of their goodies.

Now they do not want to be big time, long-term buyers, but a surgical intervention to slap the market might not be a bad gamble, The notion would be to keep the Treasury market from getting too sloppy for at least a few months till the rest of the world economy was on a bit firmer footing.

And you’d want to do it in a noisy fashion. Politically, the Chinese could not announce a move like this, for it would be badly received at home, but the Japanese might publicly announce intervention to lower the yen and then let it be known in the markets that it would be buying longer dated dollar bonds. But the buyers would want everyone to know that they were a’coming into the market, presumably in size. That would change psychology for at least a while and would give the Fed some breathing room.

The Fed did call the Bank of Japan and asked it to buy Treasuries during the 1987 crash, and the BoJ dutifully put the word out to Japanese banks. But the Fed is very unlikely to prevail on China or Japan in less than an emergency, and I doubt they’d take this course of action on their own, as much as it might, when all the bennies are factored in, be a viable near-term strategy.

Note I am not saying this is a good choice, but a “less bad” choice, and that it is a strictly short-near term gambit to catch investors off guard and reboot the bond markets at a higher price.

The bigger problem is there is no obvious end game for the US-China co-dependence. For China to build a consumer economy is a ten to twenty year process. and a movement in that direction means higher wages, lowering their competitive advantage. But as Herbert Stein said, that which is unsustainable will not be sustained, and we may see his dictum proven out sooner than anyone would like.

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20 comments

  1. bobo bobo

    Yves: Curiously, the Fed has not announced formal inflation targets. Many Fedwatchers seem to assume the implicit target is something responsible, say 2-3%, but many other commentators have argued that the Fed needs to create much higher inflation to depreciate the value of all the debt weighing down on the economy.

    ———

    I think Rogoff and others calling for high inflation haven’t thought through the lack of bargaining power that wage earners have. The only way workers will be able to get wage increases is if the US starts engaging in protectionism, immigration restrictions, and pro-union changes in labor law. I can’t see the inflationista economists liking any of these things, so their calls for inflation seem bizarre.

  2. RTD

    I’ve been warning of commodities-only inflation since the middle of last year.

    Inflation only functions as debt relief to the extent that it increases wages (higher household income reduces the debt burden of individuals) and finished goods prices (higher gross profit reduces the debt burden of firms). If inflation only increases the prices of raw materials (oil, nat gas, metals, grains, etc,) this makes both firms and consumers worse off and does not reduce the overall debt burden. It will also turn any green shoots brown quickly.

    –RueTheDay

  3. Richard Kline

    There are debts and there are debts: the question is, who’s holding? I don’t think for a second that Fed policy on pushing up inflation is in any way aimed at the _end-users_ of credit, i.e. retail consumers, including mortgage holders. It is aimed at institutional debt-instrument holders, who presently have acquired more than they can refinance in a market of falling asset values. So Ben’s idea is exactly what is stated, to return ‘normalcy’ to certain markets, that is certain credit-wholesale and securities markets. Participants there are being provided with ultra-low capital in humongous volume at public expense, to revive those markets. But there crap assets are overpriced and not moving because their nominal face values are ridiculously overstated. So the real goal is to drive up quotes by ‘forced flotation’ of said asset values. To me.

    This has nothing to do with consumers. No one in the wealth class or in government finance cares if they get better, only that they keep on paying the monthly minimum until their securitized crap can be ‘inflation adjusted’ enough to get it moving in the market again. And regardless, it is not in the interest of the wealth class to have wages or income for the other 95% increase at all: that cuts into their profits, and creates different social expectations. Notice that there is not a whisper of anything like this inside the Beltway. To the extent that we see anything, it is talk of ‘realistic expectations’ for union wage earners and pensioners, i.e. we’ll tell you how much the give back is when we’re ready.

    No one in wealth or power cares what 7-10% inflation does for the retail public so long as they keep making those monthly minimum payments until the Big Boys can offload their inflation adjusted debt and re-profit themselves on an artifically induced yield curve. Which isn’t happening, yet or likely at all, I didn’t say that this is a winning strategy. Only that it is not a mortgage end-user focused strategy. The point in dropping money-bricks from mercy copters isn’t to make the peasants happy, it’s to sustain money velocity and thereby keep bankers aloft.

  4. skippy

    So this weeks good news is…baby needs new shoes, give daddy sevens! On top of that my boss is starting to look like Johnny Depp and paying me with coca beans and a song coming on.

    Skippy…I thought mortal combat was vague and disorienting. Oh, its never gambling if its other peoples money, right.

  5. hbl

    David Rosenberg’s piece two days ago said “looking at the split between the real rate and nominals, the entire surge in Treasury yields has come from a resurrection in inflation expectations, and this in turn has coincided with the breakout in the commodity complex and breakdown in the dollar.”

    Unless this dynamic has changed in the last two days, the market doesn’t seem to be questioning the government’s ultimate solvency (yet).

    I’m not certain the Fed will have to do anything except be patient (though more QE eventually seems inevitable). If as seems likely sustained inflation can’t take hold when wages are unlikely to follow commodity prices higher, the latest inflation expectations may fade faster than they did in 2008.

    This could be accelerated by a combination of scary deflation showing up in the CPI (CalculatedRisk has pointed out that rents which make up a large part of the index have started falling but that hasn’t shown up yet in the data) and also the effect of rising rates choking off economic activity further (as Yves pointed out).

  6. Tortoise

    Yves, Strange how the same data can confirm conflicting theories to different observers. The rise in long-term interest rates in US debt is seen by some as a problem. However, I see it as evidence that growth is expected to start again, not somehow insufficient funds. There is plenty of $ in money market funds that pay less than US bonds. The steepening of the yield curve is a reflection of positive predictions about the US and world economy.

    RTD, What you call “commodities-only inflation” is dollar devaluation. First, not much of it has happened over the last twelve months and, second one positive is that it makes the US real economy more competitive.

  7. sanjay

    Unless this dynamic has changed in the last two days, the market doesn’t seem to be questioning the government’s ultimate solvency (yet).

    ________

    That clearly hasn’t happened yet- the 30 year outperformed the 10 year. That particular spread has behaved very predictably if one assumes this to be a normal interest rate move. That anybody would want to own a 30 year US govt bond is a surprise. In 2019 according to the rosy Obama administration forecasts the interest payments on the national debt will have increased to $870 billion!!

    In the end the US govt. will have two choices- inflate or default. I believe that they will default before they inflate. I believe that is the message in the narrow and in fact negative interest rate swap spreads.

  8. Joe Costello

    Its all getting more and more interesting isn’t it. The one thing we’re still seeing is the complete domination of the economic debate by the monetarists. Amazing really.

    Everyone thinks the Fed is in control, I guess we’ll see, but its beginning to look a little shaky.

    The question of starting to manipulate currencies is certainly an interesting one and fraught with danger. The bottom line is a devalued dollar will throw a wrench into the system. It serves no purpose to the corporate globalized economy model that has developed over the last 3 decades.

    The most striking thing about this crisis has been the powers that be’s efforts have been completely and totally geared to getting that model up and running again.

    To me this is the thing that rings most false and why I think we’re a long way from anything. And if we want to start talking about some official beggaring thy neighbor to get things moving, well it didn’t work too well in the 30s.

  9. donebenson

    Your comment that “there is no obvious end game for the US-China co-dependence,” tossed on to the end of this post deserves much more attention and thought.

    As this- in many ways- was a fundamental cause of the current problems, the realization that it is not easily solvable puts the longer term world economy in really difficult circumstances.

  10. RN

    Yves said:

    “…the trick is to figure out how to restructure the debt, not how to reflate an asset bubble. “

    This absolutely vital point is the most important thing in this post and arguably the most important issue facing the economy.

    Doing this is absolutely vital. There is no way to “reflate” without creating massive unexpected distortions. Further, the numbers simply don’t add up; the aggregate debt is simply too great, period.

    I wish I WISH Obama understood this. Geithner must be fired and replaced with someone who does, and who can write the policy to restructure debt fairly, quickly, and substantially.

  11. Realist Theorist

    Are there reliable figures showing the maturity-breakdown of US debt held by China and by Japan? The US has so much debt that comes due in the next 4 years (around 50% of the outstanding debt?). I’d be interested in knowing the average maturity of the Chinese debt.

    From their point of view, the Chinese should not worry about spooking the US debt market, because spooking is a temporary phenomena. If that’s what it takes to scare the US government into a position that is better for the Chinese in the longer-term, then that spooking works.

  12. ronald

    Bit and link from Accrued Interest

    “When the Treasury buying program was announced, it was assumed that the Fed had some ceiling on Treasury yields in mind. This was a logical conclusion, since classically the Fed operates with a target, and buys or sells Fed Funds to meet that target. Why not do the same with the Treasury market? Target the 10-year at 3%?

    But 3% came and went. 3.25% came and went. 3.5% came and went. The market kept waiting for the Fed to increase its purchases, but their purchase amounts have been remarkably consistent. Almost as though their only goal was to get money into the system, and they didn’t really care about where Treasury bonds actually traded.

    Helicopter Ben is trying to do just that. Print money and pass it out. He’s just using the Treasury market as his helicopter. He’s not actually trying to push yields lower.”

  13. Yves Smith

    Realist,

    China did really massive buying in 2008 and late 2007. Even if they own maturing Treasuries (sure to be true, but volume uncertain). if they do not replace them with other dollar assets, the effect would be selling dollars and buying RMB, which would push the dollar down, something they do not want.

    They and we are in a real bind here.

  14. Realist Theorist

    Yes, I guess both sides realize that the co-dependency game has been played out.

    So, what are the options? I think the options that are hard in the short term involve recognizing the new reality and painfully working toward a new scenario. The options that are easier in the short run involve trying the prolong the existing scenario…for one last dance.

    If you had to guess, who do you think will evade less and be more able to push toward a new reality: the Chinese government or the U.S. government? I’m betting the Chinese can take more pain.

    In real terms — and relative to “per capita expectations” — the Chinese government has more real wherewithal to weather a period of adjustment.

  15. VG Chicago

    the implicit [inflation] target is something responsible, say 2-3%I believe that was a typo. The correct version should read: “say, 2-3 million percent”

    Zimbabwe style…LOL

    Vinny GOLDberg

  16. VG Chicago

    An observation I thought you might find interesting: ever since I returned to Chicago, a month ago, I noticed people on the streets are much more friendly and polite then they used to be before this crisis. Now, complete strangers greet me and ask me how am I doing all the time. Very touching. The only minor inconvenience is that if I greet them back, they almost always ask me for money…

    I kind of miss the days of “W” when we at least still had our basic human dignity…

    Vinny GOLDberg

  17. VG Chicago

    Oh, I forgot to mention, but there were numerous “nice” people greeting me on the streets of the glorious United Kingdom as well. And, just like here, once I’d greet them back, they displayed an irresistible urge to ask me for money.

    Shall we cal them, “superior, erudite, noble blue-blooded British-born pan-handling beggars”? Would that be OK if we called them that?…LOL

    Vinny GOLDberg — professional Europe basher and incisive revealer of European ignorance, wherever it may hide (but especially targeting France, Spain, and Her Majesty’s glorious United Kingdom)

  18. TowelAndAChip

    Periods of stability are always followed by periods of instability. The longer the former, the longer the latter.
    The last period of instability, 1968-1982, involved taking the dollar off gold and moving towards floating currencies.
    This one, 2007-????, will involve taking the Chinese off the dollar standard and floating their currency, along with the currencies of Japan, India, and the other Asian nations that have pegged, formally or informally, their currencies to the dollar.
    In each case, they will have to learn to live without the export model they’ve become used to. Except India: India is an actual parasite on the world, and will have to learn to shed its half-assed socialism, fend for itself, and actually make useful things, in volume. In other words, come up with someone to compete with Tata, across the board.

  19. Andrew Bissell

    It’s kind of sad, watching these last, desperate efforts of the Fed to prop up a system already sickened by its prior propping efforts. They’re doomed to fail, but the more scientistic economists like Bernanke and Krugman will not understand that until the system lies broken and bloodied at their feet.

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