Arnold Kling  

Bond Market

Economics and Evolution... Roll Over, Ricardo...

Brad DeLong wonders why the bond market isn't punishing the Bush Administration harder for its fiscal sins. He lists a number of possible explanations, including

1. The people who matter in financial markets are expecting either (a) that there will be a Clinton-Democrat (i.e., Eisenhower-Republican) victory in November 2004, or (b) that Stephen Friedman, John Snow, and their allies in Congress will move in early 2005 to eviscerate Karl Rove and the other deficit doves in the Bush administration, and so restore fiscal sanity.
2. There is a genuine bond-market bubble, a bubble which will be unwound sometime in the next year or two with... interesting upward movements in ten-year Treasury bond yields.

I have argued for the bubble view myself. Also, I recommend checking J. Huston McCulloch's site every six months or so to get a read on the term structure of interest rates.

But I think that Brad may be wrong to say that the fiscal prospects of this country changed with the Bush Administration. The main determinant of the long-term fiscal outlook is the unsustainability of Social Security and Medicare. It is not clear that the probability that those programs will be fixed has fallen with the election of a Republican.

For Discussion. Are long-term interest rates in the United States too low given the fiscal outlook?

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The author at Different Opinion in a related article titled Interest Rates and Demand in a Knowledge Economy writes:
    ...As demand for investments, leisure and consumption should shoot up in anticipation of higher growth, demand for taking up loans, and hence (real) interest rates should shoot up to. This time, they haven't...the shift to the knowledge economy means t... [Tracked on January 19, 2004 11:16 AM]
The author at in a related article titled writes:
    How do we explain the bond market bubble.... [Tracked on January 21, 2004 1:28 PM]
COMMENTS (19 to date)
Chris writes:

OK, dumb question...what does this mean for people with lots of student loans, such as the Stafford program? Or other types of loans, for that matter: mortgages, home equity, credit cards. Are these interest rates tied to the Treasury bond issue?

Xavier writes:

Even if Bush is reelected, I would expect Karl Rove to have less influence over his second term. Rove is basically a political advisor. When Bush is no longer worried about reelection, what purpose does he serve?

It seems to me that fiscal irresponsibility is usually caused by political desperation. Is there any evidence that second-term presidents are more fiscally responsible than first-term presidents? If so, the effect would probably be more evident in the Bush administration because the vice president is not being groomed as his successor.

"Are long-term interest rates in the United States too low given the fiscal outlook?"

Yes, yes, yes. In my opinion, a good portion of the Treasury buying is lemming-like ie, if I'm a money manager, and I'm measured against an Index, then I need to buy Treasuries since they constitute 30%+ (I think) of the Index, AND all my peers are doing so. And of course, Fannie and Freddie are also having a significant impact with their mortgage-related hedging. Still not sure if this explains the entire scenario..

Lawrance George Lux writes:

Brad DeLong was right about the amount of Treasuries necessary to be bought in Asia, the current rate will not sustain, though the Bush administration will not stop excess spending. China has a problem, where they must start buying Oil and American products with their Dollars, their Banking system cannot afford more Treasuries under conditions of a dropping value Dollar. Their Yaun bonds would collapse.

Interest rates are far too low in both Short-term and Long-term. The Short-term rates (this low) incite Delayed Production Payments schedules (they are paid, but the Cost transferred to debt), business inefficiency, and short-stocking of Inventory. Long-term low Interest rates removed alternative investment advantage, leading to inflated Stock market prices, with reduced actaul Stock dividend return. lgl

drk writes:

household debt service payments as a percentage of disposable personal income are near historical highs, in large part due to the white-hot housing market of the past year, which in turn has lowered owner's equity as a percentage of household real estate to record low levels. (mortgage delinquency rates are falling however, altho foreclosures still remain high.) as well personal savings rates are near record lows, which is fine as long as home values, stock portfolios and productivity continue to move higher.

this is in large part because interest rates (and inflation) overall are so low, which cannot be appreciated unless the current account deficit is taken into consideration since foreigners are now funding about half the US federal budget deficit, i.e. they're buying half of all treasuries issued by the gov't.

if you include the current account deficit in the analysis then, and took foreign central banks (the primary buyers of late) out of the equation, then interest rates ceteris paribus would be higher, which would then raise the gov't's cost of servicing its debt... at which point debasing the currency (e.g. printing dollars to pay for expensive manned explorations into outerspace) would no longer be as effective a policy and thus limit gov't largesse.

looking at the budget deficit separately without taking this into account assumes the gov't can issue an unlimited amount of bills, notes and bonds to finance increasing levels of public spending without raising taxes (cutting them even) because overseas demand for 'the safest investment in the world' will absorb it all.

yet this is manifestly untrue. moody's has even mentioned a possible downgrade of US sovereign debt:

Moody's Investors Service cautions that reduced spending, more taxes, or some combination of the two will likely be necessary at some point for the federal government to avoid debt levels not compatible with the Aaa rating category.
the financial times has also called out the administration:
The US has taken advantage of the depth and liquidity of global financial markets to live beyond its means, covering its federal deficit by borrowing abroad. But the US is big enough that relying on the world's savers to finance its deficits will, eventually, raise global interest rates.
The administration's reaction to the IMF's criticism was to intone the mantra that it plans to halve the federal deficit in five years. Higher economic growth, it says, will raise tax receipts. But as a commitment to long-term fiscal responsibility, this is disingenuousness bordering on dishonesty. [also on iraq btw]
while the economist article spells it out: is more likely that higher taxes will play the largest part in plugging the deficit. The question, then, is whether the process of plugging begins sooner or later. Either way, Americans will soon have to accept that federal spending is rising to a permanently higher level, ... [more detail here]
yes, the US has the capacity to spend beyond its means, and it has and it can for quite awhile more given its unique position of maintaining the world's main reference and reserve currency. moreover, it can do so indefinitely as long as its borrowers feel that the money is being put to good work, and invested toward improving the productive capacity of the nation, i.e. allowing the US to pay back its obligations with interest, without having to resort to debasing its currency.

the last part is crucial, because as the dollar continues to decline, holders of US obligations will increasingly wonder if the US is 'good for it'. at which point perceptions can become reality, i.e. if the US is believed to be approaching an argentina-style meltdown, there is very little anyone can do about it nevermind the US' protestations.

so far the administration has been able to get away with tax cuts, new spending and the unfunded mandates that go with them through increased borrowing, especially from abroad, which have helped keep interest rates low. japan in particular has been particularly acquiescent by selling $187 billion in yen last year to support the dollar, the majority of which was parked into US treasuries. [good explanation here].

this was all done in service to global reflation (recall that deflation over the past few years was a financial market and economic bugaboo). japan, and much of asia, fears having their currencies appreciate and having their export economies slip back into recession, more than any potential for a US default, which technically is impossible. the US can always just print more money.

the problem is the administration has taken advantage of this situation with relish, perhaps as it should. but the more the world economy continues to improve the more fickle bond investors become; less reliant on the US as a 'safe haven' and more willing to diversify to higher yielding instruments denominated in a stable currency, unlike the dollar which has been steadily declining since its peak in march 2002 (about the time steel tariffs were mplemented btw). now many forecasters predict a continued fall in the dollar, because of low interest rates and lack of fiscal discipline.

to prevent the steady drip of dollar liquidation onto the forehead of america, the US will have to eventually raise interest rates and reign in deficit spending, maybe even a lot. how will the housing market and stock portfolios fare then? what had been virtuous is becoming a vice, and while unlikely to be completely forsaken, the US increasingly faces the prospect of a painful readjustment. that's why so many have told the US to take its bitter medicine now, before the fever pitch.

Barry Ritholtz writes:


You asked the following: "Are long-term interest rates in the United States too low given the fiscal outlook?"

Consider the more intriguing phrasing: "What do the present low interest rates tell us about the near and long term fiscal outlook for the United States?"

The answer, I suspect, is a lack of demand for capital, in the form of loans or investment.

The tech/telecom bubble was characterized by a massive overinvestment in equipment, factories, etc. Huge overcapacity was the result. The excess capacity -- and lack of new demand -- is the problem.

So is this a real expansionary period, a true economic recovery -- or is it merely a "trillion dollar party," as Ned Davis called it?

If this was a true recovery, why is there so little demand for capital? Interest rates RISE in a normal, healthy expansion; why not this time?

The question you ask very often shapes the answers you get back . . .

Bernard Yomtov writes:


The rates on student loans are tied to Treasury rates. What it means is that if you have sucha loan and have the opportunity to lock in your rate, it's a goodidea to do so. I think they sometimes call this "consolidating" the loan.

As far as the others go, they sometimes are. Home equity credit lines, for example, are often floating, and some mortgages (ARM's) are also. The implicationis that if you have such a loan your payments are going to go up

It brings up an interesting question. Given that ARM's and the like are more popular now than they used to be, will a rise in interest rates have a stronger dampening effect on the economy than in the past?

Mcwop writes:

Seems many here are sure that rates are too low. If some are so sure of rates, tehn what should rates be?

Let's not forget simple mechanics. There is ample demand for Treasuries, which will not go away overnight. The dollar is weaker against the Euro, but remember that the Euro was in the crapper not to long ago so the Euro has corrected up (when people realize that Euro members are busting their budget agreements this will change). The Fed Reserve has interest rates set low, and bond rates are correlated to Fed Reserve policy. When Greenspan hikes rates it will likely be in 25 bps increments. So if rates go up 25 bps, the 10 year bond mught move about 5% down in price.

Lastly inflation is very low, and if you believe in deflation these days then rates are in the right palce. Brad Delong needs to get over his hate for Bush, and belief that only a President's policies move markets. There is more to it than that.

David Thomson writes:

“Brad Delong needs to get over his hate for Bush, and belief that only a President's policies move markets. There is more to it than that. “

Brad DeLong is making a fool himself. I have not hesitated to criticize President Bush for many of his economic decisions. Still, it is absurd to believe that the Democrats would not be far worse if they got into office. Al this stuff about Robert Rubin and Bill Clinton balancing the budget is something out of the distant past. The current crop of Democrat candidates are like drunken sailors when it comes to government spending for nonmilitary items. There is no doubt in mind but the stock market and other financial indices would drop significantly if the odds increased against the man now residing in the White House. Lastly, I suspect that the markets are betting the Republicans will do much to address the spending problems---after the election! Nothing is going to be done before that time.

Eric Krieg writes:

DeLong is blinded by his liberal politics, as usual.

Economic policy does not exist in a vacuum. If international investors are going to take their money out of the US, they need to get a better return elsewhere.

I challenge anyone to find a better investment climate anywhere else in the world. Even now, the US has better growth prospects than any other country on earth.

And don't forget that the Japanese and Chinese are almost forced to buy T-bills to maintain their economic growth. If they stopped reinvesting their trade dollars, the value of the yen and yuan would surge.

I like Honda and Sony as much as the next guy, but does anyone think that they would be competitive at 80 yen to the dollar?

And anyway, the dollar isn't that cheap. It is just off some lofty highs. It is no cheaper than it was in the early 1990s (the last time we had a huge budget deficit, I recall).

Mats writes:

Are rates too low? Well, according to the classic veiw that rates fundamentally should equal expected inflation plus expected economic growth, they probably are. If outsourcing and digitization has altered the formation of supply, demand and capital, rates may be just fine at this level.

Ray writes:

I can still remember the hulabaloo in the 80s and how the evil President Reagan was allowing the dollar to rise too far; thus causing job losses and a dangerously high level of foreign investment. Remember when the Brad DeLongs of the day were predicting that Seattle and all of California would be Japanese owned.

Assuming DeLong has something of a clue, he is simply playing on the economic ignorance of the public.

Kahn writes:

I challenge anyone to find a better investment climate anywhere else in the world.

You don't have to look too hard; it seems there's plenty.

Remember real long term interest rates, among other things, should reflect market expectations of the potential for real long term economic growth. Falling real rates then may mean the locus of global growth may be shifting elsewhere...

Lawrance George Lux writes:

The low Interest rates are too low, though I can't remember the counterbalanced Studies of the 1960s on the Issue--help Anyone? At rates below 1.75%, there will be an erosion of actual Capital acculumation. Interest rates below 3.1% will destroy the systemic buying patterns of about 27% of the consumer populations, as they have to switch to uneven withdrawal systems of investment. Business investment will optimize marginal production activities, inciting regressive capitalization, if the Prime rate is below 4%.

The devaluation of the Dollar is a positive for the Economy, the excess Government spending is not! The schedule of foreign purchase of U.S. Treasuries should decline with the total size of the Debt, and previous holding of Treasuries in the face of a declining Dollar. lgl

Eric Krieg writes:

Kahn, the difference is that the Chinese aren't buying Australian government debt to reinvest their trade dollars. So I'm not so impressed with the fact that other governments' debts are going for interest rates higher than ours are.

The Chinese and Japanese demand very specific bonds: US T-bills. If they didn't, the yen would be trading at about 80 to the dollar in pretty short order. It's sort of like a captive market.

Mcwop writes:

Foreign buying of US bonds reaches record see link.

Story Here

dook writes:

i think you have to be careful about what you mean by "foreign" buying (or "chinese and japanese demand"). i can't find the series, but the treasury i believe does break out official and private (non-official?) capital flows, in addition to the type of security as Mcwop's link points out.

most of the buying in the last quarter was done by asian central banks, although thankfully it seems private demand for US assets has picked up some (at least in november, the latest january figures suggest it hasn't lasted, and that what buying there is is hedged implying low confidence in a sustained dollar turnaround).

and yeah, there was a barron's article a while back on anecdotal evidence of lack of confidence in fannie and freddie paper by foreigners so they're switching to asset-backed securities instead. so the latest treasury data appears to be confirming this switch.

i think it is worrisome that you're seeing asian central bank balance sheets balloon. like this headline:

"Asian forex reserves at $1.9 tln, up 33 pct in 2003"

remember the S&L crisis, when insolvent zombie firms were lent money well beyond the point when they were insolvent? because of moral hazard and they didn't have anything to lose, they took on greater and riskier loans, nevermind that it always ends badly waiting for the big payoff that's just around the corner. and the telltale sign that something was amiss? rapdily expanding balance-sheets.*

um, but there's a difference here right? america can't be insolvent right? really, there's no way... ever. triple-A all the way. we can keep on spending, cuz we're the engine of the world's economy, the buyer of last resort. it's okay, we can cut taxes because it made the recession the shallowest in history. oh wait now lets make 'em permanent. laffer curve. oh and uh technology. and there was the war, there's no way we could not spend on that. and spend on that. military budget go. productivity miracle. oh and it's an election year, prescription drug benefits for all and lets go to mars while we're at it. we'll also protect our jobs from foreign competition and increase subsidies to farmers, thanks.

that's being facetious, but the point is that despite it all much of the world, such as mr. krieg, still thinks the US has the best investment climate in the world. so we're in good company**... on the road to hell! j/k, all that matters is they're getting there faster :D

*apparently japan's been sterilizing their interventions by offloading ridiculously expensive JGBs onto the postal system, which if you recall is where the majority of japanese have their life savings, i.e. they've assumed a lot of interest rate risk

**it does limit america's range of options, however. for example imagine the administration pursuing rumsfeldian/neocon instincts to treat china as a "strategic competitor"

eric krieg writes:

ok dook. Where's the beef? Where is the better investment opportunity than here?

Robert Schwartz writes:

As an investor, I see Treasuries close to an all time high and I think that there is a lot more capital risk than capital gains potential in being long, esp at 10 years and up. Now, the largest part of this assement is mathmatical. Rates have a floor (0%)and Bond prices a ceiling (par + coupon) and a floor (0). Bonds are very much closer to the ceiling than they are to the floor.

If the efficent market hypothesis holds for bonds, the price impounds all information available to all market participants. It is only too high or too low if there is information that is not public that will affect prices. Such information can exist (i.e. terrorist attacks), but things like fiscal policy and trade balances occur in public and cannot be the basis of superior knowledge.

If you think that the market is wrong, you can make a lot of money by means of the right investments, but the wrong ones will lose. My advice is don't bet the ranch -- mad money only. Use instruments like options, that do not have unhedged or unlimited downside. And good luck.

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