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Why U.S. yields are low
A quick post, inspired by silly things I’ve seen in the financial media.
The U.S. 10-year yield is about 1.8%, down from just over 2% before Cyprus. Some people say Treasury prices are rising because the Fed is buying up so much of the debt stock, though Sumner reminds us that this is not so (the PPPS at the bottom).
Instead of falling because of QEIII, U.S. treasury yields are low (despite a firmer recovery) because of developments in Europe.
I think this plot says it all:
That is a correlation of -0.79, between U.S. bonds and the Spain-Germany spread. Correlation does lift the odds of causation, just not that much.
Think of U.S. bond prices as a function of 1. NGDP expectations and 2. a “haven fee” which goes up when EMU default risk rises. Before the QEIII framework was in place, we couldn’t be sure if Europe was mostly affecting U.S. yield through #1 or #2 , but it is plainly obvious to anyone who watches financial markets carefully that Europe is the driver. You’d have to come up with one hell of a just-so model to explain how quantitative easing is able to push down U.S. yields (which is supposedly bullish) while also seemingly exacerbating the Euro Zone mess. Why the negative correlation?
Since the Bernanke-Evans rule went into effect, Treasury yields have still moved opposite the Spain-Germany spread, but commodity prices, TIPS spreads and stocks all tell us that NGDP is set to grow around 4%. So I am fairly confident that most of recent weakness in yields springs from the “haven fee” effect.
Funny isn’t it? The staunchly anti American “Europe” project is now indirectly subsidizing the U.S. Treasury.
PS: I’m not meaning to be a jingoistic Yank by pointing out that the U.S. Treasury is getting a subsidy from the European Commission. I’m just taking a swing at the EU, which has brought so much trouble to the continent.
A look at the 1987 stock market crash
I liken the ’87 crash to that sequence in Pulp Fiction where John Travolta accidentally shoots the man sitting in the back of Samuel L. Jackson’s car. Stick with me. The mistaken shot is the stock market crash (or maybe the rally before the crash), and Travolta and Jackson are the financial market participants. The two frantically seek shelter in Quentin Tarantino’s house, uncertain of how the situation can be resolved. They call Ving Rhames (representing Alan Greenspan) in a panic. Greenspan calmly answers by sending Harvey Keitel (monetary easing) and all is well…at least for a while.
This (not safe for work) clip from the film is at least what came to my mind when a macro professor explained the ’87 crash to me some years ago. Everyone freaked, Greenspan said he was on the problem, cut rates, and “confidence” was maintained. When people speak of financial market confidence, they really mean the implicit NGDP forecast hidden in market prices.
In January I posted about a method I was toying with for estimating the market’s underlying NGDP forecast. I have some results, and will post something soon. But before that, I’d like to share some principal component graphs I’ve made along the way, which support the Mr.Wolf interpretation of October 1987. You can click the graphs below for a closer look.
To start, lets look at the first principal component from: the ten year Treasury yield and logs of the S&P 500, West Texas Intermediate month ahead futures, the major currencies, trade weighted dollar index, and three month copper futures. These are somewhat arbitrarily chosen, just what I was able to get back to ’86 without hassling my Datastream source too much. The component was calculated from mid 1986 to early 2013, though in this first graph I focus on the ’87 crash. If you are new to principal components, think of this series as a sort of multidimensional midpoint of the five series, the scale has no meaning.
I’ve proposed that principal components like this are proportional to expected NGDP in some way. In the next post we’ll see that lagged values of these components are strongly correlated with NGDP. If the component really is a proxy for NGDP expectations (the true stance of monetary policy in the Market Monetarist model), then it would seem that expected NGDP certainly dipped abruptly on Black Monday, but not catastrophically so. Put simply, the ’87 crash didn’t much shake NGDP expectations.
Now let’s look at the market prices themselves. I’ll show fewer days of trading in these plots, because it becomes too messy to get a clear read on October ’87 if I show as much as I did in the graph above. Also, note that the dates are in YYYY-MM-DD format for these plots.
If you read Sumner in 2010, you’ll quickly see the difference between ’87 and ’08/’09.
This graph of 20 day log differences shows us that oil traders were unimpressed with the stock market collapse. Oil prices didn’t fall until weeks later when stocks were rallying. Copper prices plunged on black Monday (that abrupt drop just before the 1987-10-26 date marker), but quickly rallied thereafter.
Next, the S&P 500 index along with the U.S. dollar index:
This is a fascinating graph. The dollar strengthened on Black Monday, but then quickly weakened as monetary policy eased. I had to double check the figures; I couldn’t believe the dollar fell 10% in a quarter, but it happened. This is the opposite of what we saw in late 2008 when the dollar soared.
The last constituent of the component is the five year yield:
The 5 year yield shot up before the crash, plunged back to August 1987 levels on Black Monday and then held steady for the rest of the year.
Lastly, here is a plot of the component in 2008-2009. This really needs to be mapped to an NGDP forecast to easily interpret (next post) but still gives a rough sense of how different the two market crashes were.
We already knew that market NGDP expectations held up in ’87 and plunged in 2008/2009. I view this more as a test of the principal component approach. This doesn’t mean the component is really mirroring NGDP expectations, but if I’d seen a sustained drop in the component after Black Monday, it would be back to the proverbial drawing board. Failure to reject is something.
Oförändrad…
Sweden has been amongst the most interesting economies to watch in the last decade. Sadly, things are becoming even more interesting on the monetary policy front. Since about mid-2011, the Riksbank has turned from the bold imposer of negative interest rates, to the timid, fretting institution we know today. Despite most forecasters expecting a steady if not catastrophic rise in joblessness this year, a flatlined CPI and a strengthening currency, the Riksbank chose to leave rates unchanged today. Note that this does not mean that monetary policy was unchanged. Quite the contrary, Swedish monetary policy was tightened meaningfully.
After the news broke, the Swedish krona appreciated about 1% against the euro. Keeping in mind that the euro has rallied lately, on both slightly tighter ECB policy and easier Japanese and American policy, the drop in the euro to below 8.50 is jarring. The “equilibrium” FX rate is probably around 9.20. I’m pressed for time, but I suspect the OMX Stocholm index fell and government bond yields as well.
It is interesting how the krona didn’t strengthen all at once. It first gained about 0.6%, and then it looks like Stefan Ingves started talking to reporters, whereupon the full seriousness of Sweden’s plight became clear.
I’ve now lost nearly all faith in the Riksbank. They’ll cut rates again in 2013 I’m sure, but only after NGDP expectations have waned further. If the U.K. can hire a Canadian as its central bank head, why can’t America hire a Swede? Because Svensson is clearly not appreciated in Stockholm.
Some things never change
Paul Krugman is again on the warpath against doing anything about the U.S. deficit. Nothing new here.
Here is a link to the interview I’m talking about.
Krugman says that there is no case for lower spending now, and that we had better wait three or five years before cutting. I grant he is right that the U.S. federal government could hold off for a while yet, but that seems like a second, or even fourth best policy option when we have technologies like printing presses and asset markets.
Another thing to keep in mind when discussing any hypothetical future policy to be undertaken by America’s federal government is that Americans reelected George W. Bush and then turned down an opportunity to elect a hyper-achieving Mormon. I guess they get some credit for dodging Palin in the senate but can the public really be trusted to elect a new emperor president with enough guts to shutdown counterproductive NATO bases and cut funding for expensive end-of-life treatments? Nixon went to China and Obama could cut federal spending now. It is the right thing to do and would make democrats out of millions of disillusioned Republicans. Krugman should say so, as he knows what happens when the central bank has a nominal target and a framework for open ended QE.
Oddly, Krugman cites workers “loosing touch with employment” as a reason not to cut spending today. This doesn’t pass the proverbial smell test. The U.S. has added about 150,000 jobs a month for half a year, or about 30k more per month than America needs to bring the unemployment rate lower. It would seem to me that, even if we lived in a Keynesian world, the economy is strong enough to weather at least some meaningful deficit reduction—$300b off 2014?—without more unemployment. This could be done in this hypothetical Keynesian world by simply cutting unemployment benefits, or at least breaking the link between job search and unemployment payments to encourage people to take lesser jobs rather than stay at home, work on the black market, or wait for the perfect job. Cutting unemployment benefits is controversial, but the link between higher jobless benefits and higher unemployment is perhaps the most robust finding in labor economics! I know we can do better.
Krugman of course is just saying whatever he thinks will help the left. But kindly remember that all 50 states are bigger than Iceland, so you can still try to build your social utopia at the state level with all that NGDP which would be freed up from federal use. My home state has sort of already done this by building a broad welfare system of its own.
Ultimately, Krugman is not a honest broker, and of course I am hardly the first to say it. Despite his intelligence, he is visibly rooting for a team, which is revoltingly unscientific and should cost him more credibility than it has. One could say that the great Milton Friedman was also rooting for a team to a certain extent, but he was always so kind and didn’t contradict earlier things he had said without acknowledging the shift in his thinking.
Adding market expectations to our models
Scott Sumner’s blog taught us to look at market prices as functions of of underlying market forecasts, with NGDP expectations playing a leading roll. If you watch markets closely, you’ll soon see that there are different types of “days” on the markets. Some days are really obvious revisions to the U.S. (and world) NGDP forecast. If—in USD terms—the yen rises while the euro, GBP, S&P 500, longer term yields and commodity prices fall, then we have an obvious case of lower NGDP expectations. If yields drift a bit lower while stocks drift a bit higher and the various commodity contracts—say WTI, Brent and copper—take rather small steps in opposite directions, then the market has little new to say about future NGDP on that day.
I think I’m closing in on a way to capture the market’s underlying NGDP forecast.
Here is what I propose, as a start:
Take daily time series data, closing prices, on 5-year U.S. government bonds, 5 year TIPS spreads, the broad trade-weighted dollar index, the S&P500, WTI front month contract prices and LME front month copper prices.
We should all agree that an ‘exogenous’ change in the market NGDP forecast, will yield a change in all of these market prices. Say, something like the Fed cutting rates more or less than expected, ditto QE. If you don’t believe that, then either you are allowing your ego-investment in decades of New Keynesian thinking to cloud your judgement, or you haven’t read Nunes and Cole’s new book. (I haven’t either, but I will and can only assume the content would lead one to this understanding)
So my idea is to take the first principal component of these time series, and treat it as in some way proportional to future NGDP. Lars did something similar a few months back. The resulting component wouldn’t be interpretable as an NGDP forecast, but we could aggregate it to quarterly frequency and use it to drive an NGDP forecast equation. We would need many equations actually, to find the “NGDP expectations curve” (which would be like this inflation curve) and in turn find the expected NGDP path. I deliberately included only 5 year bond yields, to weight the factor on 5 year NGDP expectations, though maybe 2 or 3 year rates would be better.
Here is a graph of the proposed shadow forecast.
And here is a graph of the same series, from 2007 to December 2012.
I’ve pondered just what this component might mean, and so far my best verbal description, is that the component is directly proportional to the expected present value of all income earned in the next five years. Exactly what geographical entities the series applies to are not clear, though it is surely dominated by the U.S.
I’ve played around with forecasting NGDP from this series. So far it is a respectable indicator of contemporaneous NGDP (when I convert the series to quarterly frequency) as well as NGDP up to 3 quarters ahead, after which it loses performance quickly, which is not surprising given how NGDP expectations have been buffeted in recent years. I don’t think those results are worth showing yet, but am confident there is a lot to be done with this, one way or another. My goal is to eventually build a website which somehow maps market prices to expected NGDP, in real time. It should be possible for a bank or forecasting firm to build a comprehensive line forecast products based on market data, which would allow clients real time forecast updates and perhaps finally give us an intellectually honest forecast methodology.
Regardless of how NGDP expectations are ultimately found (Scott has a link to an Evan Soltas article on another approach), we need a good estimate. If Market Monetarism is the best family of macroeconomic models for our age, then it follows that the best macroeconometric models will probably be built around market NGDP expectations in one way or another.
What Do Markets Think of the Fiscal Cliff?
I’m not too worried about this fiscal cliff. My guess is that it won’t even lead to a recession, if we do ‘go over’, but rather a marked slowing in RGDP for a quarter or so. I think the economy would look as it did before QEII.
In a situation like this, the thing to do is to look at the markets to get a sense of what they foresee. However reading markets is not so straightforward in this situation. Unlike monetary policy, which is more or less neutral in its impact on the composition of aggregate demand (where the ‘money goes first’), fiscal policy is by definition nonneutral. If the government cuts the military’s equipment budget, then military contractors stand to lose more than others.
Because it is big corporations which stand to lose the most (or if you are an anoying libertarian, ‘their shareholders’) from the fiscal cliff, the stockmarket might be a less useful forecasting tool than bond yields or commodity prices. At least if your reference index is dominated by government-linked corporations.
Oil prices and bond yields don’t look like they are discounting a recession. Oil prices (West texas intermediate) have held in the mid to high $80s while TIPS spreads and bond yields have been fairly steady. As of Friday afternoon, December 28 WTI front month contracts were trading around $90 and the ten year bond yield is at 1.71%.
If we would say that there is a 40% chance of taking on the full fiscal cliff, and that markets are already discounting this, I would say that the full fiscal cliff would not have the sort of disasterous consequences some fear. At least this is what the markets say to me.
Some regions would be hard-hit, but the recovery would survive.
What exports can tell us about the ‘fiscal cliff’
A leading reason I question the Keynesian fear of rapid government spending cuts, is that there are lots of quasi-exogenous downshifts in GDP components that don’t lead to recession, at least when you have your own central bank, or dominate the ECB (Germany). For example, the great recession undercut exports in (nearly?) all countries, but [edit:the drop in exports] had no predictable impact on NGDP and thus the business cycle. This suggests that some other force was steering NGDP (could it be monetary policy?) and as a result, that the U.S. might be able to print its way through the fiscal cliff if need be. After all, when we are talking about the ‘output gap’, a drop in spending is a drop in spending, be it from the lost wages of a laid off worker in an export industry or government.
Take a look at this graph:
The graph shows the share of exports in nominal GDP for a selection of economies which held up well (Australia, Poland and Israel) in the great recession or at least recovered quickly thereafter (Germany, Sweden). It is striking that exports never recovered to the prerecession share of NGDP in Israel and Australia, countries which did not even go into recession in 2008-2009. This means that the economy was able to shift quickly from exports to domestic consumption, presumably because the central banks were essentially level targeting. Given that Australia was mostly exporting commodities, and Israel, a set of diverse high tech goods (if memory serves), it seems unlikely that exporters simply began selling to the domestic market. Rather, other industries picked up the slack.
This ‘real shock’ aspect of an export collapse makes me even more confident that the economy can easily handle a rapid fiscal tightening. A drop in export demand is a real shock, you lose part of your ability to realize comparative advantage. If the iron ore market tanks, then Australia can’t just ramp up production at the Vegemite factory and quickly make an equivalently valuable quantity of output (this sentence shows how tenuous real output measures are). However, if you layoff government funded nurses and weapons engineers (the as the U.S. may do soon), they can easily get jobs in the private sector, so long as the Fed level targets NGDP, keeps the flow of economy-wide spending rising at a steady rate.
In all likelihood, the fiscal cliff would lead to a marked slowing in NGDP growth, and maybe even a short recession, given the timidity the Fed has showed us these last 4 years. So we are back to asking congress to play the role of AD manager.
America Downgraded…
Apparently a firm by the name of Egan-Jones (never heard of them either) downgraded the U.S. federal government from AA to AA-. They think that QEIII harms the economy. Way to harsh my mellow guys. Apparently Egan and Jones think the SRAS curve is vertical, and that the extra AD will just cause inflation. Of course I think they are wrong, and instead see QEIII increasing tax revenue while probably still failing to wholly make up for 4 years of unprecedentedly low inflation.
Tax revenue is first and foremost a function of nominal GDP. Changes in the path of nominal GDP drive revenue up or down in a nonlinear way, just look at the marked drop in U.S. tax revenue after the Volker disinflation or after the 2001 slowdown. Looks like we can expect QEIII to lift nominal tax revenue, so long as it boosts NGDP. As far as maintaining purchasing power, inflation expectations are still low.
This upstart ratings agency has it all backwards, which is a shame as we could use more competition in bond rating. Monetary easing is the only way to restore U.S. tax revenue growth. Cutting federal spending and tweaking rates doesn’t move the parameters of the tax function much. Unless the U.S. congress really overhauls the tax code, say with a VAT, there is little lawmakers can do to control revenue, short of hiring better central bankers. I often blush when I hear a finance minister or treasury official give a bold proclamation about how budget X will do Y to the fiscal balance, especially in countries which don’t have independent or NGDP stabilizing monetary systems (most big, rich countries). Budget calculations are conditional on aggregate spending, and NGDP can always move higher or lower than the finance department reckoned, throwing off the core assumption. This is why Euro Zone government’s keep embarrassing themselves by missing deficit targets. They have no idea where NGDP will be.
But back to the U.S. downgrade. The U.S. government has given bond investors fantastic returns over the past four years, and bonds as measured by the TLT fund (below) are still trading at sky high valuations.
Since 2009 U.S. consumer prices have climbed at the slowest rate since the 1930s. As a result American treasury investors have made bank, indeed bond investors who loaded up on treasuries in 2007 has made far more than they ever dreamed. Moreover, as the U.S. dollar has done fairly well—though for all the wrong reasons—most foreign investors have also cashed in with U.S. debt. If QEIII moves the dollar back toward its prerecession range, 10 year yields back around 3% and inflation between 2-3% (a best case scenario); the Fed would have…brought us back to a set of relative prices which prevailed when unemployment was 6%. That is, when the U.S. credit rating was AAA at all of the serious ratings agencies, plus these Egan-Jones fellows.
So please disregard all the nonsense about QEIII harming America. QEIII is a big step in the right direction.
Odd Moves in the Markets
This blog is not dead, I swear. Though living in Pennsylvania may be slowly killing me, or at least weighing on my will to write.
Here are a few observations from today’s market moves:
1. Stocks went up a lot in Europe and the U.S.
2.Yields fell in troubled EMU markets, and rose in the U.S.
1 and 2 imply that markets forecast stronger growth.
3. Commodities…generally fell. WTI, Brent, and copper all fell somewhat. Consistent with either slightly lower growth/supply expectations, or just noise.
These moves are incoherent to me. Combined with the fact that everyone more or less knew on Wednesday what Draghi would say Thursday, lead me to believe that markets are not terribly impressed with the new ECB move. I don’t understand why commodities didn’t rally when stocks did so well, perhaps one can get an odd result like this when the tail risk of a Fall (autumn) 2008 type event is meaningfully lowered, which seems to be all that the new ECB program is good for.
In other news, Sweden’s Riksbank cut the repo rate a quarter point. This was wise. They needed to do something to bring the crown back into a more grounded range against the Euro, to scare of some of the haven buyers and to stoke domestic demand. With Finland and Denmark in recession, Sweden once again looks like the smartest country since Switzerland (two of the top three most secretly arrogant democracies). I’d like to see them cut rates one more time this year, but that might be hoping for too much. I wish I had been short the SEK now, seems an obvious trade looking back. I closed my short Euro position at 1.25, though if it goes back toward 1.30 I’ll probably go short again, always bet against politicians…
Clarida Doesn’t Understand Macro
Check out this clip on Bloomberg.
Richard Clarida (the man in the interview) along with Jordi Gali and Mark Gertler did a lot of the leg work in building the New Kenyesian paradigm. It is disheartening to hear him say such wrongheaded things. Inflation is low in the U.S., unemployment is high. Obviously there is an AD problem. Clarida’s own models say that economic performance could be boosted by lifting inflation expectations. This makes me want to buy treasuries.
