Bond Market

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?

“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..

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:

…it 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.

Chris,

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?

“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.

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.

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…

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.

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 😀

*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”

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.