Sunday, February 08, 2004

O Debt, Where Is Thy Sting? 
This isn't exactly war-related, but I couldn't let it go by.

The New York Times has a story on the increasing federal budget deficit, essentially expressing astonishment at the fact that despite the increasing flow of red ink, the bond market doesn't seem to have flinched.
Here's the nut of the story:

So what is the reaction from the bond market vigilantes, those disciplinarians who bid up interest rates whenever past deficits started looming? Yawn.

Since Mr. Bush released his budget proposal on Monday, forecasting a $521 billion shortfall for the current fiscal year, the interest rate on 10-year Treasury notes has actually fallen slightly, closing on Friday at 4.08 percent. Since August, when the deficit estimate was $475 billion, the rate has dropped from about 4.4 percent.

The bond market, it seems, has stopped worrying and learned to love the deficit. The question, of course, is whether everybody else can relax, too.

The conventional wisdom, of course, is that high deficits leads to high interest rates. It's a matter of supply and demand. When federal deficits rise, the government must issue more bonds to cover the deficit. When the supply of treasuries increases, their price falls, and yields must therefore rise.

The conventional wisdom is at once simple, elegant, and wrong. The bond market vigilantes the reporter mentions are a figment of his imagination. A boogie-man. At least when it comes to federal deficits.

The Times reporter makes the common error of assuming that the 10 year treasury note should act as a proxy for the entirety of the debt market. But not all maturities behave the same way, or move in the same direction. Prices on short- and long-term treasuries can often move in opposite directions, for the simple reason that the biggest bugaboo for long term bondholders isn't the federal deficit at all, but inflation. Which to the long term bondholder, can be a killer.

Don't believe me? Ask anyone who held long-term debt through the 1970s, when real returns (read, inflation-adjusted returns) on supposedly safe treasuries and mortgage-backed securities actually turned negative for extended periods of time, thanks to skyrocketing inflation.

Once inflation got out of control, the only way bondholders could unload them was by slashing their prices: The only way it made sense to own bonds--or lend money at all--was to jack up interest rates to a level which ensured profitability even after 12%, 15%, 18% inflation.

It wasn't even inflation that did it. It was the expectation of even more inflation which drove up interest rates. And the longer the bond, the bigger the inflation allowance that had to be built into the interest rate.

Somehow, the New York Times managed to write a three page piece on the relationship between deficits and bond prices, and even try to explain away the muted reaction of the Treasury market, without even once mentioning the lack of inflationary expectations.

In fact, just a few months back, some analysts were actually worrying about a deflationary cycle, in the midst of the recession.

Look at the Reagan era. Between 1981 and 1989, interest rates for most maturities fell sharply, despite sharply mounting deficits which nearly doubled the national debt.

The difference? Under the Paul Volker chairmanship, the Federal Reserve Board of Governors built up some major credibility among bond vigilantes with its ruthless willingness to hike short-term rates, even in the midst of a crippling recession.

In the name of combating inflation, the Fed sold Treasury bonds to decrease the money supply, and hiked short-term rates until labor markets writhed in agony. And then they hiked them again. Inflation was tamed; workers were devastated.

Bondholders cheered.

Bondholders cheered, and waived much of the premium they were charging on new mortgages and other longer term loans as a hedge against inflation. Interest rates fell, bond prices rose, the value of intangible assets rose almost across the board, and investors grew rich.

Bondholders have long memories. And Greenspan's Fed is still enjoying the fruits of the credibility bought dearly, and at a terrible price, by Paul Volker's board.

Bondholders remain confident that the Federal Reserve is vigilant against the danger of inflation, and so interest rates on longer treasuries can remain steady, or even decrease, despite increasing deficits.

When it comes to 10 year + bonds and the deficit, the bond vigilante is a fairy tale. The historical correlation between interest rates and the budget deficit is actually negative.

When it comes to inflation, though, the bond vigilante is Charles Bronson on steroids.

But somehow, in a two-page article on this precise subject, the Times missed any mention of inflationary expectations whatsoever.

But if low inflation is something we now take for granted, that may be evidence of how far we've come.

Splash, out


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