Federal actions on QE2 have been relatively benign up to this week. (See my Monday post: http://seekingalpha.com/article/240375-federal-reserve-qe2-watch-part-1.)
Things were different this week as the United States Treasury issued a lot of bonds this week and longer terms interest rates rose to levels not seen since the middle of June 2010. The 10-year Treasury security got up to almost 3.30 percent on Wednesday, up by about 45 basis points over the past two weeks or so.
The Federal Reserve added over $32 billion in Treasury notes and bonds to its portfolio from Wednesday December 1 to Wednesday December 8. This move was not to replace mortgage backed securities as was the case over the past few weeks.
Also, this increase was not to replace reserves lost through operating transactions. Quite the contrary, deposits with Federal Reserve Banks other than reserve balances, which includes the General Account of the United States Treasury fell by almost $8 billion which also added reserves to the banking system.
All-in-all, over $50 billion was added to Reserve Balances with Federal Reserve Banks over the past week. Most, if not all of this will show up in Excess Reserves at commercial banks.
In August 2008, before the Fed started pumping reserves into the banking system, total reserves at all commercial banks totaled $46.4 billion!
The initial interpretation of this is that the Fed acted to keep long term interest rates from rising further. The ten-year bond rate was down slightly today, closing around 3.23 percent at 4:00 PM, New York time. This is what QE2 is supposedly all about!
Showing posts with label Bond yields. Show all posts
Showing posts with label Bond yields. Show all posts
Thursday, December 9, 2010
Thursday, May 14, 2009
Prices Continue to Rise
"The Labor Department reported that prices received by producers of finished goods rose 0.3 percent last month, further blunting the prospect that the economy was veering into a vicious cycle of lower prices and lower wages known as deflation.” (See http://www.nytimes.com/2009/05/15/business/economy/15econ.html?hp.) Analysts continue to be amazed that we have not yet moved into a deflationary spiral, given the weakness in the economy.
The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.
The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.
The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.
Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.
The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.
What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.
Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.
Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.
Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!
So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.
The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.
There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.
This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.
In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.
Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.
Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.
The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.
The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.
The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.
Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.
The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.
What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.
Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.
Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.
Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!
So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.
The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.
There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.
This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.
In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.
Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.
Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.
Thursday, April 30, 2009
Long Term Bond Yields and the Fed
The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”
Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.
The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.
The rationale given for this slippage? The record amounts of debt the United States government has to sell.
It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.
The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.
My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!
My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!
I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.
This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.
If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.
In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.
And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.
The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.
Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.
In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.
A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.
Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.
Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.
The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.
The rationale given for this slippage? The record amounts of debt the United States government has to sell.
It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.
The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.
My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!
My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!
I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.
This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.
If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.
In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.
And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.
The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.
Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.
In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.
A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.
Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.
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