Thursday, May 07, 2009

Wither the Treasuries

U.S. Treasury Bond interest rates rising. Especially for longer-term Treasuries -- the three-month note is still hovering at around 0%. There's multiple possible interpretations possible here:

  1. Investors now have inflationary expectations. This is Bloomberg's preferred interpretation, and possibly the most optimistic one no matter how gloomily Bloomberg paints it. The deal is that if investors have inflationary expectations then they will move money out of treasuries and other "mattress" instruments (i.e., places to park money because you expect the money to be worth more in the future, i.e., because you expect deflation) and into productive investments within the economy, thereby spurring economic activity. In addition, if banks have inflationary expectations, they will start loaning money rather than hoarding money because they will expect their money to be worth less in the future, thus it will make more sense to get it out of their vaults and into appreciating financial instruments ASAP. In this interpretation, a rise in Treasury interest rates is a *good* thing, and means that the Fed's policy of monetary easing has produced the desired results -- inflationary expectations that will swiftly produce the real thing (which, as I've pointed out in the past, is a *good* thing within reason since inflation is what mobilizes the resources of the economy by drawing money out from under mattresses and out of bank vaults).
  2. Deflation has resulted in a shortage of investment capital within the economy as a whole, as too much money has already fled out of the economy and is hiding under (virtual) mattresses where it does not contribute to economic activity. In this interpretation the problem is a shortage of cash, requiring the Treasury to pay out a higher interest rate to get people to buy their bonds. In this interpretation, the proper response is for the Federal Reserve to intervene even more massively, perhaps by buying massive numbers of long-term Treasuries at these treasury auctions.
  3. The inflation in the amount of the deficit has outrun the amount of capital available to finance the deficit, resulting in a need for higher interest rates to attract sufficient capital to finance the deficit.
So which interpretation is correct? The doom and gloom sorts go for #2. They're like Captain Kirk to the inflation-hawks' Mr. Scott, shouting "More money, more money, we need more money!" as the inflation hawks say "We canno go no faster, Captain! She'll blow into hyperinflation!" They handwave away the effectively 0% interest rate on short-term Treasuries by saying that this is just a case of people shoving money under mattresses using the short-term Treasuries rather than lumpy mattress, and that the reason they're going short-term bonds for their mattress-stuffing is because they're almost as liquid as cash stuffed under the mattress.

The "Things are turning up!" crowd, on the other hand, sees the difference in interest rates between short and long term Treasuries as meaning that in the long term the market does see an increase in economic activity coming along with inflation. #1 is the optimist's choice. In their view, the reason why long-term Treasuries' interest rates are heading up is because investors are seeing higher returns for their long-term investments if they invest now rather than waiting for later, and thus the Treasury must pay more interest to attract these investors to Treasuries instead. In short, investors have inflationary expectations and are acting in ways that will cause more economic activity, thus pulling money out from under mattresses to fund economic activity rather than to make lumpy mattresses. They hand-wave away the effectively 0% interest rate on short-term Treasuries by noting that right now the short-term corporate bond market is dysfunctional so anybody needing to park money short-term while they are seeking out good long-term investments is likely going to park them in short-term Treasuries instead.

And finally, there's the doom and gloomers of the #3 "government is too big!" family. Problem for them is that money doesn't just disappear into a black hole when the Treasury buys bonds. It gets re-deposited into banks as economic activity and is then added to the money supply again. The Treasury is just recycling money, it's not vaporizing money. So #3 fails into #2 -- i.e., if the Treasury can't get enough money without paying big interest rates, it's because of deflation, and the solution is to have Helicopter Ben crank up his helicopter fleet and throw yet more dough out the windows.

So what's going on? Well, I need to find some more data points to give you any clue as to which of the above is true (or none of the above). I'm leaning towards a combination of #1 and #2 with a teensie bit of #3, personally -- i.e., that we're seeing inflationary expectations start to take hold (that's a *good* thing since it will pull mattress money out from the Fed's vaults and back into producing economic activity), but that we need to make sure this gets lubricated and not stifled by high interest rates so having the Fed purchase long-term Treasuries at auction to drive down their interest rates a bit would be some nice pump-priming to keep Treasuries from pulling investment money away from other productive investments during this period of deflated money supply. In short, I'm not the #2 option's Captain Kirk shouting "More Money, Mr. Bernanke Scott!" but I do believe some quantitative easing is still necessary, just that it must be carefully targetted. I'm decidedly not the #2 critic's "Mr. Scott" shouting "she's gonna blow into hyperinflation, Captain!". One Treasury auction at a not-particularly-high 4.3% interest does *not* mean that we're facing hyperinflation!

Indeed, 4.3%, historically speaking, isn't a particularly high interest rate for 30 year Treasuries. It's only high by comparison to recent months of deflationary expectations, and indeed, if the overall expectation from investors is that we face 4.3% inflation over the next 30 years, I'll take it. That's not a bad rate of inflation at all, and will serve well to perform the usual job of inflation in a capitalist economy, which is to draw money out from under mattresses and into the economy where it can fuel actual economic activity rather than just being lumpy mattress stuffing.

So anyhow, I'm keeping my eyes open. We'll see soon enough who's right -- or if nobody is right, including me :-). I'll just say that, regardless of which of the above is true, one thing is clear: Something new is happening. Whether this is good or bad is yet to be known.

-- Badtux the Somewhat Optimist Penguin


  1. How about #4: recent decisions in China have reduced the global demand for long-term treasuries, absent any other change in the macroeconomic picture.

  2. That may be, but if so, it's basically #1 in economic terms, since if they aren't putting the dough into long-term Treasuries they're putting it *somewhere*, probably into investments they view as more renumerative over the long term. Just more proof of inflationary expectations amongst a very *large* investor in this case...

    - Badtux the Economics Penguin

  3. Apologies for being snarky, but did you mean to say remunerative?

  4. Why, yes, said the penguin to the spider :-).

  5. I expect to keep doing just fine, I've never depended much on money to get by. Money is just something I piss away on beer and women.

  6. I love your title, BT.

    Now, where does BBC live and is he available?


    Preparing for the end of times

  7. The #2 deflationary depression camp is not made up of just pessimist. I am at heart an optimist. My embrace of this position is based on my sense of current reality and not some perennial apocalyptic fear that everything will one day collapse. In fact, I have thought of multiple solutions to get the country out of the economic trap it is now in. A strong belief that there is hope is optimism in its truest form.

    There are two forms of money. One is actual cash on hand in the form of ultimate wealth. The other is access to cash to generate purchasing power. The modern economy runs on purchasing power generated by access to credit. Inflation is simply too much money chasing to few goods and deflation is simply too little money chasing too many goods. When people with bad credit, no job, and no money down were gifted 1/2 million dollar homes to live in for free for a while we had a situation where we had too much purchasing power chasing too few goods. Currently, it is very difficult for anyone with a subprime credit score to borrow money to buy a home or a car. And those are the people with jobs who can make a small down payment. Even people with good jobs and good credit cannot longer get no money down mortgages. So purchasing power (money supply) in the Main Street global economy has significantly contracted. After-all, over half of the country has a subprime credit score and their numbers are growing daily. Combine this with the capital losses and deleveraging on Wall Street where you also have had a severe contraction of purchasing power in the bond market and presto, a recipe for deflation.

    Hence, we will sell half the houses and homes that we sold a couple of years ago unless people with subprime credit can regain purchasing power. And, we have a deficit of capital in the bond market waiting on new capital from earnings and savings, or waiting on more leverage. Since the global economy is in a depression there are limits to the amount of new capital that can be created at this time. Perhaps the rise in interest rates due to a bad auction is partially because there is not enough purchasing power in the bond market to absorb the massive quantity of new federal debt.

    My solution is to crank up the printing presses and purchase $10 trillion worth of U.S. Treasuries. Treasuries are the desired form of mattress stuffing by institutions. The goal is to take away the mattress.

    There is no risk of hyper-inflation entering the U.S. economy. None, zip, zero, nada. Only one major modern industrial economy in the world has ever witnessed hyper-inflation being of course Germany in the early 1920's. Zimbabwe is not comparable to the U.S. While there are multiple reasons Germany experienced hyper-inflation, the largest single cause were heavy war reparations owed in other currencies beside the mark. Chiefly Germany owed Britain pounds and they owed France francs. Germany ran out of gold in 1922 and wound up in a viscous circle of needing to print more and more money to generate francs or pounds. The U.S. owes everyone dollars. To repay China its one trillion dollars we need only print one trillion dollars. And unlike Germany we have numerous hard assets and technologies to offer in trade such as coal or wheat or pharmaceuticals.


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