Wednesday, November 13, 2013

The Return of the Bond Zombies (excerpt)

I think that the 10-year Treasury yield could be in a trading range between 2.5%-3.5% through 2014 and maybe beyond. That’s mostly because I think that inflation is dead, and likely to flat-line around 1% for the foreseeable future. My “Bond Vigilantes” model for the bond yield simply compares it to the y/y growth rate in nominal GDP.

This model shows that since 1953, the yield has fluctuated around the growth of GDP. They both tend to be volatile. As a result, they rarely coincide. When they diverge, the model forces us to explain why this is happening and can reveal important inflection points in the relationship. Here’s a brief history of this relationship:

(1) During the 1950s-1970s, investors consistently underestimated inflation. Bond yields rose during this period, but remained consistently below nominal GDP growth.

(2) That changed during the 1980s when investors belatedly turned much more wary of inflation, just as it was heading downwards. Nevertheless, the yield tended to trade above the growth in nominal GDP. The July 27, 1983 issue of my commentary was titled, “Bond Investors Are The Economy’s Bond Vigilantes.” I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”

(3) During the 1980s and 1990s, there were several episodes where rising bond yields slowed the economy. The heydays of the Bond Vigilantes were during the first term of the Clinton administration, which adopted policies aimed at placating them. Indeed, Clinton political adviser James Carville said at the time that “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

(4) During the previous decade, the Fed kept the federal funds rate too low for too long mostly on fears of deflation. As a result, bond yields remained mostly below nominal GDP growth. Mortgage rates and mortgage lending standards were too low. The result was a huge bubble in housing, which led to the Great Recession.

(5) Over the past five years, the Fed’s response to the anemic recovery following the Great Recession has been to peg the federal funds rate near zero and to purchase bonds. The Bond Vigilantes were buried by the Fed’s ultra-easy policies. However, the Bond Zombies rose from the dead during the spring and summer! The yield rebounded back close to the growth rate of nominal GDP, which was 3.1% during Q3.

Today's Morning Briefing: New Normal Is Bullish. (1) Hit-and-miss ultra-easy monetary policy. (2) Getting back to business. (3) PIMCO’s spin on the new “new normal.” (4) Ambiguous advice. (5) A brief history of the “Bond Vigilantes” model of the bond yield. (6) Bond Zombies. (7) The Fed was horrified. (8) Where is the exit door? (9) Before and after 2008. (10) Signs of life in World-ex US revenues. (11) OECD leading indicators looking good for advanced economies, and not so good for BRICs. (More for subscribers.)

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