14 Comments

This is mistaking technically-motivated trading behavior for fundamentally-motivated trading behavior. Rates are low because traders understand that the central bank will defend the price point. No one has more ammunition than the Fed. It is a broken indicator because the "independent" central bank is, through open market operations, not even acting through intermediaries like it could, defending a high price.

The public discourse is polluted on this topic perhaps because many simlar types of price manipulation are illegal in regulated securities markets when done by a mere pleb. The Fed is wash trading bonds, but without the concealment that would normally accompany wash trading. In the most charitable reading of what the Fed is doing, they would counter that the openness of open market operations makes it distinctly different from crimes like market manipulation and wash trading.

So, in reading such arguments like the one you're writing, my objection internally is that you (and others writing similar arguments) typically do not address the elephant in the market, which are the open market operations. If you look at the recent and planned treasury buying activity published by the NY Fed, you have to ask yourself, do I or any reasonably conceivable band of bond vigilantes have more capital to blow than $50-$80 billion per month? https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/treasury-securities/treasury-securities-operational-details#monthly-details

Plus, there's good reason to believe that the member banks will join the NY Fed and others to defend the price point, because it's what the government needs. It's not just the prospect of 'fighting the Fed,' but fighting all the component banks as well who are all bound to one purpose: the suppression of systemic risk. The other issue with this argument that treasuries are an inflation indicator is that if they are, the correlation has badly broken down with the recent spout of highly correlated price increases. It's not actually stupid; you're just missing the fundamental factors driving this market. The prices accurately reflect the political arrangement here.

Expand full comment

If we are looking for "The bond market's guess about future inflation", then aren't 'breakeven rates' (adjusted for liquidity premium, see below) better than the mere fact that some bonds are being purchased at expected negative real return?

As for negative real rates, seems to me those have been around for a while, especially in other countries. That's usually explained in terms of (a) low growth (b) safety premium, and (c) distortions from government-directed demand: public purchases, regulatory / capital requirements, and so forth.

Unadjusted breakeven inflation rates are definitely higher right now, 5 and 10 year at around the top of the range during the past 20 years. It's pretty volatile right now, but eyeballing it, it looks about 1% higher than the average for the five years prior to pandemic (PP is the new BC). That's not really that high in the scheme of things, but that indicates the market is pricing in above 2% inflation for years.

"If you thought that inflation was going to average much more than 2 percent over the next three years, you would never invest in securities yielding just 1 percent. Instead, for example, you could invest in Treasury inflation-indexed securities, which protect you against higher rates of inflation."

Some claim that the TIPS market is distorted by two premiums - one from scarcity (the Treasury doesn't sell 'enough' of them for all the people who want to hedge that way) and the other deriving from liquidity issues. I don't know if the combination of those factors could account for actual market expectations of inflation being significantly different from the apparent indicators of spreads / breakeven rates, so any finance professionals or whizzes please chime in!

Expand full comment

"I am certainly not buying any three-year Treasury notes that aren’t indexed for inflation."

Me either. I do wonder why you have faith in the people who define the index.

Expand full comment
founding

I find it difficult,given today's circumstances,to use bond interest rates as an indicator or forecaster of inflation rates. Take a look here https://fred.stlouisfed.org/series/DPSACBW027SBOG. In the last year bank deposits have increased by approximately 1.8 trillion dollars. The banks do not pay much if anything in the way of interest on those deposits. So, they, as usual, acquire short term liablilities (deposits) and purchase longer term assets. Even at the paltry current interest rates on treasuries, the difference between those rates and 0 look very attractive. The inflastion rate has no consequences on that spread.

Of course, this raises the question: Why do depositors hold bank deposits? How long will they continue to do so. If they decide to hold a different asset, what will they hold? If they turn to gold or simply currency because they lose trust in the banks, we will see a rapid rise in interest rates that will reflect the expected inflation rate. Until then, we'll have to settle on high inflation and low interest rates.

I don't know what motivates bank depositors, but I suspect some form of wide spread risk aversion that gets satisfied by holding bank deposits even though they pay little or nothing. Because of that, I wouldn't call the depositors stupid without showing that the risk aversion has no basis.

Expand full comment

Freeman is wrong to say this is the worst negative return. Look at 1942 and 1946. I expect inflation now to be about as transitory as it was then. I.e. genuinely transitory, but not in the way that Team Transitory wants us to imagine. I'm short bond futures.

Expand full comment
Dec 21, 2021·edited Dec 21, 2021

A bond trader I follow on Twitter has been predicting for six months that bonds would go up, regardless of inflation news, because of forced buying by banks who have to meet some sort of capital requirements that I am extremely vague on and that may or may not have been related to temporary COVID regulatory changes that were going to expire. He was very confident last summer and he hasn't been shown to be wrong yet.

He's also an extreme bear and puts a decent chance on an eventual financial implosion and/or recession that he thinks will lead to deflation in certain sectors, I believe that was the more speculative part of his bullish on bonds long term thesis.

Expand full comment

A complication is that Treasuries can often be used much like cash, for things like margin requirements. So if an investor needs to maintain a large cash position, substituting Treasuries improves yield slightly, even if the return looks negative. A smaller effect than the Fed keeping rates low, of course.

Expand full comment

A recession will put the 10Y under zero, and the 30 Y under 1%. This is likely what the bond market is telling us today.

Expand full comment
Comment deleted
Expand full comment