Treasury Bonds Signaling Recovery or Armageddon?

The Wall Street Journal commented in a puff piece on the recent rise in interest rates:

Count us among the optimists who think this is good news, a sign that markets are concluding that the economy is improving as major policy obstacles recede and the risk of deflation vanishes, if it ever existed.

This graph shows the dramatic rise which commenced in early October.

Ben Bernanke stated the objective of QE2 was to lower interest rates (or at least to maintain them at low levels). Clearly that has not happened. Whether Bernanke was wrong again or possibly masking some other reason for QE2 is not relevant to judging the Journal’s optimism. It likely is relevant in judging Bernanke and his capacity to do his job properly.

Interest rates are clearly rising. Most people, including Bernanke, would consider that bad news for the economy because higher rates generally dampen business investment and hiring. Ultimately they translate into lower stock prices because of the discounting process assumed to value future cash flows. They certainly are bad news for the government deficit as new debt and rollover debt will be financed at higher rates than projected, increasing the deficits.

Is the WSJ rationalizing this news in an effort to produce a “green-shoot?” Are they being pollyannish in order to bolster confidence in markets and the economy? Or, is there validity in their claim?

All prices, including bonds, are ultimately determined by the interaction of supply and demand. The WSJ believes the demand for Treasuries has decreased as a result of investor increased confidence in the economy. Investors who fled to Treasuries as a safe haven are now believed to be leaving Treasuries and returning to riskier assets. That process reduces the demand for Treasuries, causing their prices to drop and interest rates to rise. That is the basis of the WSJ’s claim.

While they have focused on one reason for interest rates to rise, there are other reasons. None of the others allow for optimism. Demand for Treasuries would drop if people believed Treasuries no longer were a safe investment. Interest rates are also affected by supply changes. We know the supply of Treasuries is increasing, with no apparent end in sight according to government budgets. Either of these two reasons are at least as plausible to me as the one cited by the Journal. Yet both are antithetical to the expectation for an improving economy.

The Fisher Equation

Irving Fisher

The difficulty with economics is that it is complex and multi-variabled with many decision makers. Irving Fisher, a famous American monetary economist, used a conceptual model to deal with interest rates. Fisher decomposed the nominal rate of interest into several parts:

R(n) = R(rf) + R(u) + R(p),

where:

  • R(n) is the nominal interest rate (the interest rate we see and are quoted)
  • R(rf) is the risk-free interest rate (what the interest rate would be for a security with no default risk)
  • R(u) is the uncertainty premium to compensate for default risk
  • R(p) is the purchasing power risk (the risk that your dollars will be worth less in purchasing power, due to inflation, when they are paid back)

In words, the nominal interest rate is made up of the risk-free rate plus the risk premium for default plus the premium for anticipated inflation. The nominal interest rate is the only one that we actually know. It is the rate quoted (or calculated) when we purchase a home, buy a car or buy a bond. The others are not seen or truly known. They are conceptual constructs.

There is literally a Fisher equation for each and every debt instrument, although only one is needed for pedagogical purposes.

From the WSJ article, it is unclear which of the variables they believe to be responsible for the rise. I suspect R(rf) or R(p) or both. They would not consider a rise in R(u) a positive as will be dealt with below.

The Keynesian Influence

An increase in either R(rf) or R(p) would raise interest rates. To assume that a change in R(p) is a positive development requires a Keynesian mindset. Only Keynesians believe that increased inflation can be a good thing. The belief derives from their mistaken notion that aggregate demand is the primary driver of inflation. Keynesians believe there can be no inflation with an “output gap,” their description of inadequate aggregate demand. If inflation is expected to increase it must be due to aggregate demand rising and the output gap closing.  This belief continues to be held despite the stagflation of the 1970s when inflation and inadequate aggregate demand co-existed despite Keynesianism’s belief that could not occur.

The all-encompassing animal spirits can never be rejected as a Keynesian explanation. Presumably a shift in animal spirits could increase the risk-free rate of return. R(rf), while not considered constant, is generally considered stable, certainly more so than the other two components in the equation. R(rf) is presumed to be influenced primarily by individual time preferences and anticipated returns on capital, depending upon your economic religion. It is doubtful that R(rf) could have a big enough impact to account for the large move up in the 10-year rates.

The Fatal Factor

The term R(u) represents the risk of default. For Treasury securities, that risk has traditionally been assumed to be zero. That is, it has been assumed that the Federal government cannot default. This assumption is becoming more suspect as we see the problems in Europe, the balance sheet of the US government, the insolvency of various welfare programs and the coming bankruptcies of various states. Sovereign risk is so apparent that the ratings agencies have threatened downgrading the credit rating of the US government. From Reuters:

Moody’s warned Monday that it could move a step closer to cutting the U.S. AAA rating if President Obama’s tax and unemployment benefit package becomes law.  The plan agreed to by President Obama and Republican leaders last week could push up debt levels, increasing the likelihood of a negative outlook on the United States rating in the coming two years, the ratings agency said.

Neither rises in R(rf) or R(p) are likely to produce a meaningful beneficial effect on the economy. The component that could have the most dramatic impact on interest rates and a strictly negative effect on the economy is a perception that the US government could default. Is this what is driving rates higher? I don’t know, but neither does the WSJ.

Anyone who says he knows what is moving interest rates (or stock prices, for that matter) is speculating. In a free country everyone has a right to an opinion and speculation. The interpretation by the WSJ could be correct. Time will eventually provide a judgment.

Investors should weigh the impact of alternative interpretations to what the Journal has suggested. In my opinion, there is a greater chance of the rise in interest rates signaling negatives rather than positives for the economy. In the event that US bonds are seen to be risky rather than risk-free, there may be more likelihood for an economic apocalypse rather than recovery.

Michael Snyder provides ten reasons why he believes we could be nearing disaster rather than recovery.

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4 Comments

  1. “The belief derives from their mistaken notion that aggregate demand is the primary driver of inflation. Keynesians believe there can be no inflation with an “output gap,” their description of inadequate aggregate demand. If inflation is expected to increase it must be due to aggregate demand rising and the output gap closing. This belief continues to be held despite the stagflation of the 1970s when inflation and inadequate aggregate demand co-existed despite Keynesianism’s belief that could not occur.”

    In order to still maintain that belief, one must simply ignore the ’70s stagflation. It is akin to saying, in the immortal words of Mythbuster Adam Savage, “I reject your reality and substitute my own”.

    Question:
    Aren’t you conflating interest rates with yields? I’ll admit my understanding of the bond market is a bit superficial, but you need some way of differentiating realized interest rates in the secondary market with actual interest rates in the primary market.

    1. Ed,

      Not sure I understand your question. Most bonds have a stated interest payment for a defined period of time. Bonds generally do not state an interest rate but an interest payment. When the bond is first issued it is issued at or very near par. Let’s take a simple example: A bond sells for $1,000 with a contractual obligation to pay $50 for, say 10 years. At that point, the bond is selling for a yield of 5% and also a yield to maturity of 5%. If market conditions change, the latter two components will also change. The first (the interest payment and the amount due at maturity) always remains the same except for the passage of time (and default). Yield is 50 divided by the current price of the bond. Yield to maturity is that interest rate that will discount the future stream of payments (interest plus the repayment of 1,000) equal to the current price of the bond.

      Yield, as strictly defined, is a relatively meaningless term. Yield-to-maturity is not. It is the current rate of interest for a given security. If brand new bonds were to be issued by the same issuer, they would have to have interest payments that would initially produce a yield to maturity equal to existing bonds (without getting into term structure issues). In that respect, yield-to-maturity is the interest rate demanded in the market place for a bond security. Sometimes the term yield is loosely used to refer to yield-to-maturity. When used in that sense, yield and yield to maturity are referring to the interest rate.

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