Friday, February 15, 2019

Lipstick on a Pig: US Federal Government Debt

In this video podcast, I review the latest developments in the US federal government's budget and I explain why I disagree with the proponents of Modern Monetary Theory who claim that deficits and debt don't matter as long as the government borrows in its own currency and inflation remains subdued.

Thursday, February 7, 2019

Bonds: Doing the Unexpected

Last year, the 10-year US Treasury bond yield peaked at 3.24% on November 8 (Fig. 1). Last year, when the yield first rose above 3.00% on May 14, there was lots of chatter about how it was likely to rise to 4.00% and even 5.00%. Those forecasts were based on the widespread perception that Trump’s tax cuts would boost economic growth, inflation, and the federal deficits. In addition, the Fed had started to taper its balance sheet during October 2017, and was on track to pare its holdings of Treasuries and mortgage-related securities by $50 billion per month (Fig. 2). It was also widely expected that the Fed would hike the federal funds rate four times in 2018, which is what happened, and that the rate-hiking would continue in 2019 into 2020.

Furthermore, the Bond Vigilantes model, which correlates the bond yield with the y/y growth in nominal GDP, was bearish because the latter rose to 5.5% during Q3 (Fig. 3). But instead of moving higher toward 5.50%, the bond yield fell back below 3.00% and was at 2.70% on Tuesday.

What gives? The Dow Vigilantes screamed “no mas” at the Fed during the last three months of 2018, allowing the Bond Vigilantes to take another siesta. The Fed got the message, and the word “gradual” was first replaced with the word “patient” to describe the pace of monetary normalization by Fed Chairman Jerome Powell on January 4. The two-year Treasury yield, which tends to reflect the market’s year-ahead forecast for the federal funds rate, dropped down to that rate (at 2.38%, the midpoint of the 2.25%-2.50% range) on January 3 (Fig. 4 and Fig. 5).

Last year, I surmised that the bond yield might be “tethered” to the near-zero yields for comparable Japanese government bonds in Japan and bunds in Germany (Fig. 6). I also argued that based on my 40 years’ experience in our business, I’ve never found that supply-vs-demand analysis helped much in forecasting bond yields. It’s always been about actual inflation, expected inflation, and how the Fed was likely to respond to both. The most recent bond rally was mostly driven by a drop in the expected inflation rate embodied in the yield spread between the 10-year Treasury bond and the comparable TIPS (Fig. 7). The spread dropped 30bps since October 9, 2018 through Wednesday.

Meanwhile, the yield curve remains awfully flat, with the yield spread between the 10-year bond and the federal funds rate at only 36bps (Fig. 8). This suggests that Powell & Co. may pause rate-hiking for as long as the yield curve spread remains this close to zero. If they raise rates, they risk inverting the yield curve. That might stir up the Dow Vigilantes again.

So do federal deficits matter to the bond market? Apparently not. It’s all about inflation. If deficits boost inflation, then they will matter, as I see it.