Matthew Yglesias » What Do Bond Traders Think They Know

Nov 13th, 2009 at 3:14 pm

What Do Bond Traders Think They Know

We see here the past 30 years worth of interest rates on 30 year US government bonds:

And here’s the CBO’s projection for the volume of debt, with the “alternative fiscal scenario” being what the CBO considers to be the most realistic projection based on current policy:

It’d be interesting to know what the people buying these bonds think is going to happen. Not inflation, based on these yields.

Comments
38

Filed under: Budget, Deficit,

38 Responses to “What Do Bond Traders Think They Know”

Benny Lava Says:
November 13th, 2009 at 3:26 pm
Shhhh! Don’t tell the goldbugs. The cognitive dissonance will cause their heads to explode. I mean just think of poor Bob Roddis.
Njorl Says:
November 13th, 2009 at 3:36 pm
The goldbugs can claim that the interest rates shot up by 50% since Obama took office! That’s from about 3% to about 4.5%, but they don’t need to mention that part.
msw Says:
November 13th, 2009 at 3:38 pm
They’re thinking, “I don’t care about the returns. Subsidizing my country’s exports through exchange rate manipulation is the industrial policy we’ve chosen, and it’s clearly been a great success so far. Sure, these things will be worthless sooner or later, but even if it happened tomorrow, the industrial capacity that we gained would be well worth the sacrifice.”

You do know who’s buying those bonds, right?
rapier Says:
November 13th, 2009 at 3:41 pm
Traders and buyers are not always the same thing.

Foreign central banks buy for various reasons none of which has the slightest thing to do with investment or price. Fiduciaries around the globe buy them because essentially they have to. They are the benchmark, the ground zero of investment. Others stash their hot money in short term Treasuries, which account for over half of all outstanding and have a better chart than the bonds, because of their ultimate liquidity.

What buyers think is that US Government debt has not defaulted in 233 years and has been the worlds benchmark financial asset for perhaps a century. The constitution says they cannot be defaulted on.

What some say is that US Treasury debt and other sovereign debt is the last bubble. The government finance bubble is being blown to try and keep the others from deflating totally.

The almost parabolic slope of this trend cannot actually take place. Something will give. Something is amiss.
bluemeanies Says:
November 13th, 2009 at 3:41 pm
Does this mean we’re going to soon drop the cost of our revolving debt by retiring the double digit rates of the early 80’s Reagan/Volcker debt and replacing it with modern rates? That the cost of ‘interest on the national debt’ will start going down as long as we don’t issue double/triple the amount retire? Or is so much of the debt shorter term that 30yrs that this is a blip?
Ape Man Says:
November 13th, 2009 at 3:55 pm
blue meanies:

Long bonds constitute about 5% of federal debt, so it’s basically that last thing, although there’s a further flaw in the whole idea of “refinancing” long-term debt in this way – to retire long bonds you don’t pay the face value you pay market value, which has the difference between current interest rates and the bond’s interest rate priced in.
ed_finnerty Says:
November 13th, 2009 at 3:55 pm
they are thinking that they can get to the exits before the other guy, and/or they are informed by the fact that japans debt to GDP ratio already did this and their interest rates are lower than the US
Al Says:
November 13th, 2009 at 3:56 pm
They think they know the liquidity of the market and time frame they might have to hold on to the bonds for.
Ape Man Says:
November 13th, 2009 at 4:04 pm
“You do know who’s buying those bonds, right?”

I assume you mean China?

Does china really hold a significant percentage of our long bonds? I’d be surprised if that were the case.
rapier Says:
November 13th, 2009 at 4:09 pm
Bonds are only half the story. Actually there have been no 30 year ones issued for years, until just recently, again. The 10 year note is now the benchmark. At any rate over half the debt is in much shorter term instruments. 30 day bills have carried virtually no yield, or in other words cost, for over a year. Even 3 year notes have been below 2%. Uncle Sam is borrowing essentially free.

One problem is so much of the total debt is in the short end. That means it must constantly be rolled over. Meaning as a 30 day bill matures another must be sold to ‘roll’ it over. Throw in the relentless $150 billion a month new debt that must be raised and there is a very serious issue.

The Treasury would love to extend the maturity of it’s debt but at the tail end of the bond chart you can see the problem. Since the spike low last December yeilds have started to trend up. Thus trying to push more supply into the long end does not bode well for long rates.

The Treasury market has been distorted terribly this year by the Feds monetization. They purchased $300 billion long term Treasuries, that’s over, and $800 billion of mortgage backed securities. The sellers of the MBS paper, to the Fed, have turned around and bought Treasuries. A giant subsidy. In essence the entire $800something budget shortfall since the spring has been financed by money printing. That is winding down.

On the long term projection of the Debt/GDP, it can’t happen. Certainly not at near zero interest. Not at 3.5% for long bonds. Debt service is still only around 15% of all spending. If, well when, rates start to rise that could explode. Imagine what the repercussions would be if 30% of all spending was interest on the debt. This is hardly out of the question.

This sort of carping and sky is falling arguement isn’t new. However that chart showing the parabolic nature of projections now suggest that the crazies might be onto something. It is terrible for me to be lumped in with the Austrians and numbskull deficit morons. Still, there is a gigantic problem here. Everyting we know, every single thing, is contingent upon Uncle Sams good credit. That is being destroyed, in large part in the service of the banks and the military.
Ape Man Says:
November 13th, 2009 at 4:22 pm
I hate to bird-dog you on this, rapier, but I’m still flummoxed at the vagueness of these warnings. Specifically:

“Imagine what the repercussions would be if 30% of all spending was interest on the debt.”

I’m trying, but I got nothing. Can you help?

“Still, there is a gigantic problem here.”

OK. What is it?

“Everything… is contingent upon Uncle Sam’s good credit.”

Uncle Sam’s credit is not just “good,” it’s impregnable. Uncle Sam cannot default.
Gene Says:
November 13th, 2009 at 4:24 pm
Is that a graph of the current interst rate on the 30 year bond issued in the year on the horizontal scale (i.e., a yield curve)? Or a graph of historical interest rates? Because I can’t see how the latter is relevant to MY’s point.

And given what we’ve just seen about the irrationality of asset prices (mortgage backed securrites anyone), it seems especially contradictory for a market skeptic like MY to be using bond prices to implicitly support his argument that big deficit stimulus packages don’t lead to inflation or inflationary fears.
rapier Says:
November 13th, 2009 at 4:26 pm
The percentage of GDP chart probably does not include the SS fund. Throw in that and we are somewhere much closer to 100% (which is why they are desperate to dump SS, and probably will) It certainly does not include the liabilities for all the GSE MBS paper the congress so generously guaranteed last year, even as they have funded virtually every new mortgage in the US over the last year. If residential real estate continues to fall then throw in a few more trillions. Everywhere you look on the spending side you can see one thing, more.

Take that little break in the nacent 60degree slope of the lines. The deficit/GDP is at this very moment going up sharply, No break.
abb1 Says:
November 13th, 2009 at 4:31 pm
Gene @12 is right: this doesn’t look like a yield curve and therefore is absolutely irrelevant.
rapier Says:
November 13th, 2009 at 4:31 pm
Gene
the chart reflects the yield every single day, or in this case week. Exisiting bonds trade every day. Their price moves inversely to the yield. Well don’t let that confuse you. The chart is the daily market price. The bond issuer, Uncle Sam, pays face value.

It is best not to think to much about flation, for it will drive you mad.
rapier Says:
November 13th, 2009 at 4:36 pm
The yield curve is a relationship. The chart does not represent that. A chart of 30 years of history is irrelevent, to what prices do tomorrow or next week. It is highly relevant to where we are now and why, and suggestive of big changes if the trend changes. A trend change to higher in long term Treasuries would be a huge deal.
abb1 Says:
November 13th, 2009 at 4:54 pm
Not sure what you’re saying there rapier, but this graph says nothing about their expectation of inflation. So, the interest on the 30-year bond today is 4.5%, but what’s the interest on the 5-year bond today? If it’s 0.5%, then they expect inflation, if it’s 7%, then they expect deflation.
Gene Says:
November 13th, 2009 at 4:55 pm
Rapier Yes thank you, I know what a yield curve is and understand the relationship between interest rates and bond prices.

All that first graph tells me is that there has been a downward secualr trend in long bond interest rates over the past 20-30 years (depending on whether you want to smooth the upward blips into the overall downward trend).

But I am hard-pressed to understand how a historical rate in say 1995 tells me anything at all about “what bond traders think they know” [presumably today]. For that, I would like to see what happens to today’s yield curve in about, say, 2012 versus 2022 which are the two points at which the deficit starts to explode under the alternate scenarios.

That graph here says to me a lot more about “what Gene thinks Matt Yglesias pretends to understand but doesn’t” than anything ab0ut inflationary expectations. I know Druge said that a blog should be like a broadcast and Yglesias does a fantastic job at that, but so does a lot of talk radio.
Njorl Says:
November 13th, 2009 at 5:04 pm
So Rapier, you believe we should double count the money owed by the general fund to the social security trust fund, which in turn is owed from the social security trust fund to the recipients.

I see.

I hope you’re not an accountant.
horseball Says:
November 13th, 2009 at 5:04 pm
Dear Matt-

You need to find yourself someone knowledgeable about finance and economics to talk these things over with before posting items in this genre. You get blistered every single time, and for good reason.
JonF Says:
November 13th, 2009 at 5:57 pm
Re: they are thinking that they can get to the exits before the other guy,

Then why get in the market in the first place?7
rapier Says:
November 13th, 2009 at 6:12 pm
The what traders and buyers think in relation to that chart and then the deficit, is most interesting from the period of the peak in 82. For long rates began their long decent just as the deficit began to expand. There was much worry at the time that all the Treasury borrowing would crowd out other market borrowing and tend to keep Treasury rates high. Of course standard portfolio or investment analysis bases bond preference on inflation expectations as well.

The fact that budget deficits did not stop the downtrend in rates became a gigantic problem for the deficit scolds. Deficit scolding became strictly a political rhetorical device divorced from any macro impact on interest rates much less an inpediment to private credit expansion.

Thus while the deficit scolds never left, nobody in the financial world ever took them seriously. That 30 year chart screams that deficits don’t matter. Traders and buyers and fiduciaries stopped giving an aerial fornication about the stinking deficit.

Then too we learned that the Fed controls interest rates Interest rates have nothing to do with markets. They are dictated by The Chairman, and it was good.

The complacency is now total. The scolds still flit about because it’s good politics, not having any belief that it is a macro economic issue, just a moral one. Wherein it is immoral to give money to Negros. Liberals comforted in the fact that deficits are only good and the markets prove it more than happy to think they don’t matter.

Most buyers of Treasury debt buy it for reasons having nothing to do with investment or investment returns. Certainly not central banks. Certainly not fiduciaries who have to apportion some amount to them because that is how their funds are structured. They may flit along the curve a bit but buy they will, they have to.

To the extent that Treasury debt is a market is the extent to which a trend change to higher is fated to happen. To the extent it isn’t a market is the degree to which markets no longer describe our economic system.
Mattyoung Says:
November 13th, 2009 at 6:33 pm
Obviously the long term bond traders are telling us that entitlements will be cut. What is the basis in their opinion?

A bond trader would presume that unsustainable entitlements and spiraling commodity inflation go together. Gas prices rising 1% a month might cause more outrage than entitlement cuts, so Congress will face the lesser of the pitchforks.
rapier Says:
November 13th, 2009 at 6:51 pm
Prices and markets don’t tell us anything besides the general availability of money to invest/speculate and the preference for certain assets. Beyond that they tell us what we want to hear. Thus every day the ‘market moved higher because………” then some story. Nobody said stocks moved higher six days in a row on news that the unemployment rate reached multi decade highs. Although I could tell that story and it would be a good one. Because my story would pertain to the expectations of players for easy cheap credit as far as the eye can see.

This was a superb inquiry by MY. It brushes up against the fundamental questions that define our age.
Ape Man Says:
November 13th, 2009 at 7:09 pm
rapier:

You keep hinting at these sort of apocalyptic consequences. What are they? I’m really interested. I’m not trolling.
Sprizouse Says:
November 13th, 2009 at 7:46 pm
No offense Matt, but you don’t have any idea what you’re talking about here. This isn’t a yield curve it’s just a measure of the 30-year historical prices. Bond traders can CERTAINLY expect inflation if the shorter-term maturities have lower yields than the 30-year. All of this is basic finance.
Ian Priest Says:
November 13th, 2009 at 9:38 pm
Reminds me of the old joke:
What’s the difference between bonds and bond traders?

Bonds mature!
JackL Says:
November 13th, 2009 at 11:25 pm
The historical graph of rates DOES give information about inflationary views. This chart shows the view of the bond market at the long end of the yield curve as a function of time. It shows that a trader in, say, 1995 demanded a higher yield over the next 30 years (1995-2025) than a bond buyer does today (2009-2039). Showing a current yield curve gives you what the markets current thoughts are of interest rates from now to 30 years out.
MY’s point is that, if debt is exploding and inflation is about to take off, why are bond traders buying long-dated bonds (the kind most hurt by long periods of inflation) at rates far LOWER than their equivalent in years past?
Patrick Says:
November 14th, 2009 at 2:33 am
TIPS spread is better than price alone.

If the CBO is correct it suggests the market doesn’t just have blindspots, it is downright myopic. Its prices aren’t slow they’re downright retarded.

Seriously, consider the possibility that market dynamics make for an excellent static model; the most efficient distribution of goods given the current distribution of wealth, but completely essentially incapable of integrating future behavior into its activity in aggregate. Scary world to consider, but not much different from the world in which we live.
abb1 Says:
November 14th, 2009 at 4:48 am
The historical graph of rates DOES give information about inflationary views. It shows that a trader in, say, 1995 demanded a higher yield over the next 30 years (1995-2025) than a bond buyer does today (2009-2039).

No, by itself it doesn’t; it gives exactly zero information about inflationary views. There is just not enough info in this graph.

Interest on the 30-year bond in 1995 was 8%, but what was the inflation level in 1995? If it was 10%, then in 1995 they expected deflation.
JackL Says:
November 14th, 2009 at 7:26 am
–Interest on the 30-year bond in 1995 was 8%, but what was the inflation level in 1995? If it was 10%, then in 1995 they expected deflation.–

We are pretty much in agreement. The thing left unsaid is the assumption of a somewhat similar real return in both scenarios. If a trader in 1995 is willing to buy 8% even though inflation at the moment is 10% it is because he believes inflation rates will go down and the bond will pay off over a longer time frame. We agree. Logically, however, if a trader wants to see similar real returns by buying today that means that inflation will have to remain pretty low.

In the 1995 example, you don’t need to know what the precise level of inflation at the time of purchase nor the future inflation levels in order to know that traders are betting that it will be below their purchase yield. Otherwise, they would see no real return. Knowingly placing a bet that you believe will lose money seems to be the height of irrationality. Why purchase something yielding 5% when you believe inflation will be much higher? Thus, the graph above does show that traders are taking in some of the lowest yields in decades in exchange for lending to the government long-term. Unless they are expecting a real loss, they are willing to accept the least compensation for this inflation risk than ever (30 yrs.) before. Therefore, they must be expecting low inflation. Whether they will be right or wrong, is a different argument. Right now, they are certainly betting that inflation will be low.
rapier Says:
November 14th, 2009 at 8:01 am
The most important factor in determining the interest rate bond buyers are willing to accept is based upon the perceived risk of the bond issuer defaulting on the bond. The higher the perceived risk of default the higher the interest rate demanded by buyers.

Except this does not apply to Treasury debt, nor as a practical matter to the sovereign debt of most advanced nations. However the US Treasury is obligated by the constitution to pay off it’s bond obligations. This is what makes Treasury bonds the benchmark financial security of the world. Since there is no default risk the only factor in the pricing is the collective buyers of the worlds perceived inflation outlook.

Well not quite. (I do not mean to be condescending in the following explanation) Every single week the Treasury must sell it’s bonds, notes and bills to either raise new money or to roll over existing issues, ie. re-borrow the money. These are sold by an auction process. Thus the interest rate for the securities sold that day is determined by an actual market of supply and demand.

The Apocalypse comes in two flavors. The supply begins to overwhelm the demand. In essence this is happening at the long end now. Let me assure you that if the XXX billion of long dated Treasury securities sold this year had actually benn X billion that chart would have the 30 year yield scraping the bottom today near 2% not todays 3.6% on the 10 year note. Note that the Fed purchased $300 billion longer term notes and bonds, payed for by printing the dollars. A significant subsidy. That is over, for now. Since for the next year and probably more the Treasury will have to borrow appx. $150 billion a month supply pressure is likely to put pressure on the makets causing rates to trend higher. I can’t say what the markets should do or will do. Just saying there is a distinct possibility rates will rise. That isn’t apocalypse unless they really spike higher. Which would crush what is left of the mortgage market and have many other adverse consequenses.

The other apocalypse is if the world perceives that there is a risk of default. Let’s say the debt/GDP ratio goes to 100% or 200% and interest rates continue to rise. So that the cost of the interest on the debt rises to 20% or 25% of all outlays, not todays 15%. Since maybe half of all that debt is owned by foreigners do you think it is possible citizens might get a bit pissed that we are paying interest to the Chinese while cutting domestic spending? I thought so.

Of course the constitution says we have to pay the Chinese. So maybe now and then the Fed monetizes more and then more Treasury debt to keep rates low. All well and good, as long as this doesn’t make the dollar fall. Oh, I forgot there is another risk in Treasury debt. Currency risk.

The point of all this is that Treasury securities are a real market. An extremely odd one that is highly manipulated and driven by deep seated assumptions that may not be true. Serious but alt thinkers, mostly outside the US, now regularly posit that the Treasury will default and or the Fed will print madly and there will be an Apocalypse of some sort. If the day comes that the Treasury cannot borrow all it needs to pay the bills congress demands it will be a profound event. Not the end of the world just the end of the world as we know it. The assumption that we can borrow any amount of money, forever, is only a probability, not a certainty.
abb1 Says:
November 14th, 2009 at 8:48 am
Why purchase something yielding 5% when you believe inflation will be much higher?

Because it depends on the details, and because it’s the best yield you can get today.

Suppose the inflation rate today in 0.5%. Suppose I believe that inflation will stay 0.5% for the next 5 years and then jump to 50%. Or 500%. Or 5 million percent. Still, buying this 30-year bond now and then selling it in a couple of years would be a plausible strategy, right?
Patrick Says:
November 14th, 2009 at 10:16 am
I think the two charts say that the bond market either:

1. Doesn’t believe the CBO estimates
2. Doesn’t see a connection between deficits and inflation.

Deficits were pretty small in 1980, at the end of Carter. Yet, interest rates were very high. Deficits were very high at the end of Bush, but interest rates were very low. So, I don’t see how there is any tie in between interest rates and deficits.
Sprizouse Says:
November 14th, 2009 at 12:09 pm
No offense JackL but you really have no idea what you’re talking about and neither does MY. This is UNDERGRAD level finance we’re talking about. If short term rates are currently higher than the 30-year when it’s at 4% then bond traders are expecting deflation (or worsening economic conditions). If they’re lower than the 30-year when it’s at 4% then they’re expecting inflation. I seriously can’t stress enough how you and MY would not pass an undergrad level finance exam with your answers.

The long-term yields over history don’t reflect what bond traders expect (or as MY says “what they know”). It reflects a whole host of other things… like more investors in the 30-year (China for one) which (as you know from basic undergraduate finance) pushes prices down. Finally, all this goes without saying, but until 2009 the treasury hadn’t issued the long bond in nearly 12 years and the long bond rates were bootstrapped into MY’s little chart.
Ape Man Says:
November 14th, 2009 at 1:44 pm
I don’t take it as condescending at all. It’s important that we be explicit about our conception of the monetary system. Anything else leads to confusion. In turn I hope you won’t find my response condescending.

“Every single week the Treasury must sell it’s bonds, notes and bills to either raise new money or to roll over existing issues, ie. re-borrow the money.”

This is an extremely widespread misconception. In fact Treasury does not need to sell bonds in order to raise new money. The reverse is true – Treasury must create new money via deficit spending before it can sell securities.

What would happen if Treasury didn’t sell securities? Well, what would happen under normal conditions is that the banks holding excess reserves (which earn zero interest) would bid the overnight interbank lending rate down to zero.

Thus the Fed offers overnight securities for sale at some nonzero interest rate. You can question the wisdom of this system – it’s not 100% clear to me why the government should want the Fed funds rate to be something other than its natural rate of zero.

But the whole idea that Treasury must sell securities in order to raise money is wrong. No such need exists.
Mike S Says:
November 15th, 2009 at 10:48 am
lol. I have to laugh a bit because I 100% I know more about these markets than the right-wingers here. I am a CFA charterholder, and a CAIA charterholder.

Unless bond traders as a group expect significant deflation, current bond yields show very low inflation expectations over the next 30 years.

Also, the fact that yields got as low as 3% were the result of the flight to quality during the crisis. People were buying the safest investment in the world at any price. The safest investment in the world is U.S. Treasury debt. It was so crazy that in the secondary market for these bonds, traders would make a trade to sell a bond (note – whatever) and not deliver it, because they didn’t want to get out of treasuries.

Ape Man, are you a Mosler fan too? Looks like it from your comments. I hope one day people accept his views as you stated so well, but not too soon. It creates incredible trading opportunities for people like me.

To all those people who think that issuance of huge amounts of government debt will drive yields up, I ask you to consider Japan. In a case of a stable country without a credible currency alternative, issuance of more debt (or spending) will result in increased demand for these bonds and drive yields down. I fully expect to see long term debt in the U.S. reach the 2 handle for yield.

The risk of default situation only applies to countries forced to borrow in currencies other than their own. The U.S. has no risk of default in U.S. dollars.

Now there is the chance that the U.S. will not find buyers for the debt, which in between the two arguments proposed by rapier. But when China has many hundreds of billions worth of debt already, and has based their economy on exporting to the U.S, it seems to me like we have a built in demand from at least one partner. A decision by China to stop buying our treasuries would hurt them much more than it hurts us, at least until they build up a base of demand within their country that can absorb most of their output. This build up of demand will take at least 10 more years to accomplish.

So in the short run, I wonder where these people were during the Bush years. Note that the deficit would have been $1.1 trillion no matter what Obama did because of Bush’s policies.

It comes down to ideology vs. algebra. The algebra is going to win. These deficits are not going to harm the U.S. at all, and we are likely going to see much lower yields on Treasuries of all durations.
Was glauben die Bond-Trader wird passieren? • Börsennotizbuch Says:
November 16th, 2009 at 12:04 pm
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What Do Bond Traders Think They Know

38 Responses to “What Do Bond Traders Think They Know”

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