"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Wednesday, August 25, 2010

Krugman and the bond bubble

Ten assorted thoughts about the government bond bubble (please also see these excellent posts by Krugman and DeLong):

1. You could have earned a lot of money in bonds by following Krugman's analysis during last four years. Bond market is clearly not incorporating and reflecting the very public information from Krugman's blog in a timely manner, this means that the Efficient Market Hypothesis (EMH) is false for government bonds.

2. Rober Shiller has shown that volatility of stocks is much larger than can be explained by the news about economic fundamentals. The same applies to bonds; they are too volatile, with bubbles and anti-bubbles forming.

3. In early 2010, bonds were in the anti-bubble territory. Investors were overestimating the probability that the recovery will remain on the V shaped track. You should be allowed to talk about bond bubble only if you said bonds were cheap in early 2010, otherwise you should be using EMH.

4. Krugman has a model that says 10-year bond is trading at the right price now. The problem is that Krugman is assuming that the only tool Fed will use is zero interest rates. There is approximately 20% probability that Fed will do the right thing by restarting aggressive quantitative easing and credit easing as suggested by Bernanke in 2003. Bond market is ignoring this possibility and 10-year bond is already overpriced.

5. Many economists think that bubbles are harmful and that the Fed should actively lean against the bubbles. Well, the bond bubble is also very harmful, as bonds are pricing in extended unemployment and below-trend inflation. Bernanke should print more money ASAP in order to burst the bond bubble.

6. Fiscal stimulus can also successfully deflate the bond bubble. Tax cuts that can be reversed in the future cause no significant long term fiscal damage while stimulating the economy, healing the private sector balance sheets and containing the growth of the bond bubble.

7. Noise traders are a key source of stock market inefficiency. They are a big problem for bond market too. As asset maturities get shorter, the noise trader risk is diminished, and the short end of the bond market is pretty efficient. This means that we can rely more on the prices of short term treasuries when formulating public policy. Temporary tax cuts are a no-brainer, while it is much harder to reliably measure the NPV of infrastructure investments with long payback periods.
        There are a lot of trend-following momentum players in bonds, and a fall in Treasury bond prices would certainly induce further selling.

8. The most important noise trader in the interest rate markets is China. Authorities are pushing for a much higher level of the savings than can be justified by the preferences of the Chinese people.

9. Every bubble has faulty valuation models. There is no exception now, as we have Gluskin Sheff's David Rosenberg:
"Well, the Fed just told us that it has no intention of hiking rates for a long, long time. So, Fed tightening risks are off the table and at a time when the policy rate is almost zero. And we have a long bond yield of 3.6%. That is a 360 basis point curve from overnight to 30 years, and historically, that spread averages out to be 200bps.
        As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached. If we are right on -1% to -2% deflation in coming years as the post-bubble excesses continue to unwind, nominal yield will actually be quite juicy in “real” terms."
10. Every bubble has excessive trader sentiment, here is David Rosenberg again:
"We have also been hearing that bullish sentiment towards Treasuries is now 98%, according to some surveys, approaching the incredible 99% on December 16, 2008, right as yields were plunging to their trough (the 10-year note approaching 2%). <..>
        At the Grant’s Conference in April, Jim labeled the event we closed down together on stage as “Bonds are for losers.” Even in June, the Barron’s poll showed the vast majority of forecasters calling for higher yield activity. Now every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old shop who are now broadly filled with perma-bulls (now are calling for a 2.5% yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel."


  1. This is a bit paradoxical, because you're effectively saying that Bernanke should drive down bond prices (end the bubble) by buying bonds (doing QE). It could work, if the bond buying is interpreted as a commitment to keep the inflation rate up (or to revive the economy, which is more or less equivalent). But I'm guessing there would be a selling opportunity after the new QE is announced. Kind of as if the Fed would be saying, "Now that you guys have bought so many bonds, here's your last chance to sell."

  2. How to stimulate the economy while sidestepping debt and budget problems.

    When Hugh Dalton became the first socialist U.K. Chancellor of the Exchequer in 1947, pledged to nationalize the "commanding heights of the economy", he had a problem similar to the one we face today. His war torn economy was burdened by a huge debt. Where would he find the enormous amount of money needed to compensate the owners of the nationalized industries?

    The answer was simple, revive the centuries old British tradition of Consols and Gilt Edges... government debt obligations with a fixed 2 1/2 percent interest rate and no stated maturity.

    Our Treasury could do the following:

    1. Issue $100 billion of perpetual debt or consols at 2 1/2%.

    2. Instead of burdening our banks with a special $100 billion bailout levy, impose the lighter burden of compulsory subscription to the $100 billion of Treasury consols, which amounts to a mild, stretched out, 50-100 year "inflation tax".

    3. Use the $100 billion, supplemented by $10 billion of equity contributions, to capitalize a "National Infrastructure and Advanced Technology Corporation" (NIATC).

    4. Give the banks 40% of the board seats and voting shares, retain 40% in the Treasury, and place 20% with an independent group of experts appointed by the President.

    5. Give the NIATC the mission of financing high priority national infrastructure projects and promising technological development, leveraged with the financial and managerial participation of American finance and industry.


    1. Debt that can be repaid at our leisure, no increase in debt/GDP ratio, grandchildren and Moody's can rest peacefully.

    2. Minimal $2.5 billion annual budgetary cost.

    3. An opportunity for banks to put their resources at work in the economy, creating jobs.

    4. A good supply of Treasury obligations for banks to feed to deflation fearing, safe haven searching investors.

    Yours sincerely,

    Sam Costanzo

  3. On your first point, I think you have a common misunderstanding of the EMH. The EMH says that over a portfolio of opportunities it is very hard to beat the market weighted average. It is a prediction tool for a one event case only in the sense that the odds in a horse race are a predictive tool, i.e. the favorite is the horse most likely to win, but no-one is surprised or shocked when it doesn't. So EMH remains valid when it the outcome is different to the market favorite in any one case or even multiple cases in a row. The time when EMH becomes hard to defend is when someone develops a method that can consistently, over a portfolio of opportunities, beat the market. Of course this is really hard to test for, since with millions of investors, by shear chance, someone will do this. But say that you develop a convincing valid method; the paradox of course is that as soon as the method is widely known, the method will instantly fail (since everyone will take advantage of it and it gets arbitraged away). And if the method remains secret, then it is only of use to those who know the secret and EMH remains valid for everyone except those in the know.

    I think what you really mean to say failed is the more subtle argument that market pricing is "efficient" socially, i.e. that society is best off by having prices set by the market and not by regulation or Government decision. But that is another debate entirely and the failure of this hypothesis is not, I think, proved by your example.

  4. Andy,
    it all depends. Really serious QE announcement could simultaneously increase inflation expectations and drive the real interest rates up, leaving investors with an instant loss. Real interest rates are quite low at this time and there is not much room for them to compress if strong recovery is expected.

  5. Chris,
    point #1 was just an illustration (i.e. market-based odds could be improved by using Krugman's analysis), but not a proof. #2 is a proof that EMH is false.

  6. Is EMH true or not? I think is a silly debate, because you don´t know what damned model are thinking of the buyers and sellers. It is perhaps better to be more humble and say simply "The markets are the worse system except all the rest that you can imagine".

  7. Luis, on one level what you are saying is true, just like the democracy is the worst system except all the rest.

    But on a deeper level, it is very interesting to investigate which types of democracies work better, what are the weak points of democracies. It is the same with the markets. I am very interested in the question what types of market design are more efficient, what can be done to improve the efficiency of markets. EMH just denies that these questions should be asked.

  8. Sure, I was just joking. In any case, I tend to think that free market is better than any other alternative. And also that to suppose there are exceptions is dangerous. Sure, I was just joking. In any case, I tend to think that free market is better than any other alternative. And also that to suppose there are exceptions is dangerous. the Hayek´s hipotesis is more efficient: It is impossible to any government getting all the changing information of all participants in all the markets. The important point is that information is moving continously.


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