QE and the term structure of rates
Posted by WARREN MOSLER on March 10th, 2011
Background information first, answer later-
The Fed sets the fed funds target at their regular meetings, and lets the market then determine the term structure of rates.
That term structure of rates is therefore largely a function of anticipated future fed funds rate settings.
Then the Fed does QE- buys longer term securities at market prices- to try to bring longer term rates down, particularly mortgage rates.
But longer term rates don’t come down as much as hoped for.
Now to the point all this:
What the market place believes QE does, and not what QE actually does, is the same ‘force’ that largely determines the term structure of rates.
And so when the Fed does QE,
and the market place believes that QE will work to promote a strong economy and risk inflation,
the term structure of rates goes up in anticipation of higher fed funds rate settings by the Fed down the road.
And when the Fed ends QE,
that same market place then believes that support has been pulled from the economy,
the future is no longer as inflationary,
and the term structure of rates falls as fears of future fed funds hikes subside.
It doesn’t matter that the mainstream beliefs are wrong with regard to QE,
because the term structure of rates only reflects those same mainstream market place expectations, regardless of their actual validity.
And yes, this all highly problematic for a Fed trying to keep long rates down.
March 10th, 2011 at 6:11 pm
what are the constraints on the fed regarding future qe’s? does it run out of treasuries to buy?
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WARREN MOSLER Reply:
March 10th, 2011 at 9:26 pm
since the idea is to get tsy prices up and rates down, if they buy them all it’s mission accomplished
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AK Reply:
March 13th, 2011 at 11:43 pm
What effect would it have if the Fed directly began to buy other types of securities as well, apart from government bonds?
I ask because in Australia, the Reserve Bank buys/sells a large amount of private securities (largely residential mortgage backed securities) in its day-to-day interest rate targeting operations (it used to deal purely in government bonds up until ~2005).
Could the Fed to the same? Would it want to? What effect would it have?
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Oliver Reply:
March 14th, 2011 at 10:38 am
I believe that is what happened on a large scale under QE1. The extent to which such purchases become permanent, they should be considered fiscal, rather than monetary operations imo as privately issued liabilities essentially become government owned assets.
March 10th, 2011 at 6:48 pm
Studentee, interesting thought. Bernanke does seem to be proving to prove Keynes was wrong when he (allegedly) said, “Markets can remain irrational longer than you can remain solvent.” Oh no they can’t. :o)
Sooner or later people will figure out Larry Meyer’s magic 8 ball is perhaps not the most reliable guide to the future… hopefully sooner.
The macro model that is used by policy planners in the Fed and in government goes by the name of the Washington University Macro Model… a quarterly econometric system of roughly 600 variables, 410 equations, and 165 exogenous variables… In the present context, the important observation is that all are real-sector variables except the money supply and interest rates, the values of which are in turn fully determined by real-sector variables. In contrast to accounting models… The entire financial sector is absent. The very elements that have siphoned the life blood out of the economy have been completely off the radar screen. The FIRE was hidden behind a shield of invisibility, just pumping money into their coffers until the real economy bled out.
http://seekingalpha.com/article/148232-no-one-saw-this-economic-crisis-coming
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March 10th, 2011 at 7:21 pm
“It doesn’t matter that the mainstream beliefs are wrong with regard to QE…”
What if they were “right?” If everyone in the U.S. had your understanding, would QE then do nothing?
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WARREN MOSLER Reply:
March 10th, 2011 at 9:28 pm
makes sense!
It would just modestly lower interest rates due to the change in supply.
Term structure of rates is largely a reflection of expectations, with rest ‘technicals’ including net tsy supply
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djp Reply:
March 10th, 2011 at 10:33 pm
I think I follow the argument in the post, on the right time horizon – maybe 6 months after QE2 the ‘technical’ effects get washed out ? Where here I would include in the technicals the QE2 operations – certainly there was a very dramatic change in the estimations of those technicals on Nov 3 when they released the schedule of targeted duration. There was a very abrupt steepening at the long end as beliefs about where the buying would be changed.
I think it’s fair to include that in the ‘technicals’, but it had a very large effect, and it’s not clear how long it lasted, and how long it might take to settle back.
Could be that Gross is right in the short term 4-7 months, but longer term rates aren’t sky rocketing.
Easy way for anyone with internet access to look at the yield curve: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx
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March 10th, 2011 at 7:31 pm
“because the term structure of rates only reflects those same mainstream market place expectations, regardless of their actual validity”
1. true for the bond market at all times, with or without QE
2. wrt QE, the market is biased toward a false monetarist quantity of money interpretation, when what the Fed wants to signal is price rather than quantity
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Mr. E Reply:
March 11th, 2011 at 10:49 am
The Fed could muscle long rates down like they did in WWII.
As for 2., When will people notice Japan’s QE? I think this Bill Gross bond bet could turn out to be a good thing.
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beowulf Reply:
March 11th, 2011 at 11:38 am
Or just stop selling anything longer then 3 month T-bils and like the last World War I vet a couple of weeks ago, someday the last long bond will expire.
The World War II short term cap of .375% was fine (and it’d be great if Congress revived it permanently) but the 2.5% long bond cap was set too high so Tsy mostly issued short term and just rolled over. As a consequence, by the end of the war, the average interest rate on the war debt was less than 1%. This was before the Fed starting refunding net earnings to Tsy. If they had that policy back in the day, debt service rate would have been even lower.
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Mr. E Reply:
March 11th, 2011 at 12:03 pm
lol exactly. You’d figure that the Fed and Treasury would work together on this and have the Treasury just issue short term debt so the Fed doesn’t have to go through the exercise of QE.
But when I look at it from the Feds point of view, they believe they will have more long end ammo when backing out of QE.
I do not think this is intelligent, but this is probably what they are thinking. Additionally, how are the Bond Vigilantes ignoring the fact that while the fed might be creating inflaiton according to their paradigm, they are at the same time loading up on the very ammunition that will allow them to fight it…
beowulf Reply:
March 11th, 2011 at 2:29 pm
Yeah, the other thing Tsy and the Fed should work together on is figuring out how to fund public investments projects through the Fed (ideally, under existing statutory authority).
Michael Hudson mentions in Superimperialism a plan during the Nixon Administration to enjoy benefits of imports without the demand leakage. Importers would put current account surpluses in bonds issued by a Public Development Corporation (sort of like the Federal Financing Bank Nixon created just before he was bounced from office). The PDC (dba FFB) would be used to fund public investments off budget.
To quote Hudson…
The proceeds would be loaned to U.S. municipalities, states, and other agencies, for urban development, housing schools, transportation, sewage treatment plants, and other needed improvements… In addition to lowering domestic tax needs, congressional restraints over government spending programs abroad and at home would be removed. The proposal would establish a virtual perpetual motion vehicle for the U.S. federal spending. The government would run a domestic budgetary and balance-of-payments deficit… These dollars would accrue to foreign central banks, which would re-lend them to finance America’s development rather than that of their own economies. (chapter 14)
OMB defines public investment as infrastructure, R&D and education so the Fed and Tsy’s in-house Federal Financing Bank could fill our national shortfalls in these areas off budget while neutralizing the trade deficit (“a virtual perpetual motion vehicle”). Heck, if short terms were capped near current IOR/FFR rate, Fed could just deduct debt service from Tsy’s earnings refund.
Mr. E Reply:
March 11th, 2011 at 11:38 pm
That’s a crazy idea that makes me think of China and their exchange rate policy.
I need to hear more about this – I’ll get the book
March 10th, 2011 at 7:33 pm
Bill Gross has been preaching that the only thing standing in the way of much higher interest rates has been Fed QE-2 purchases of Treasury securities and his view holds sway over many market participants.
However, another constituency in the market rightly or wrongly equates QE-2 asset purchases with printing money which may fuel inflation and hence be a reason to sell bonds.
This second group seems to have been the dominant force from the outset of QE-2, and it all ties in with the sell the dollar / buy commodities trade which are all variations on the same underlying theme.
Now it is clear that that PIMCO was one of the driving forces behind the selling of Treasuries right from the start of QE-2. Presumably nothing would please Bill Gross more than to see a lot of lemmings follow his lead and bail out of bonds only to have him buy them back when the selling has driven prices down and yields up enough.
Problem is that when the news broke that PIMCO was out of Treasuries…entirely…it didn’t garner and more reflexive bond selling. In fact just the opposite occurred as a stellar 10yr auction triggered a rally in bonds. Likewise for a better than expected 30yr auction on Thursday which shifted into overdrive afterward when reports broke the tape that Saudi police had fired on demonstrators which only boosted demand for the safety of Treasuries.
How long can PIMCO and other fellow travelers afford to maintain a zero percent allocation to Treasuries if interest rates continue to go down?
The answer is that PIMCO’s Total Return Fund which is the largest bond fund in the world, can afford to hold out a lot longer than a highly leveraged hedge fund like say Long Term Capital Management. However, PIMCO can underperform for a quarter or two…maybe until say the end of June…and then he must buy.
I am reminded of General George S. Patton who when asked about the Siegfried Line responded: “Fixed fortifications are monuments to man’s stupidity.” The question is: Does Bill Gross suffer from Siegfried Syndrome? I reckon not.
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Tom Hickey Reply:
March 10th, 2011 at 8:18 pm
Gundlach disagrees with Gross.
http://www.reuters.com/article/2011/03/10/businesspro-us-usa-gundlach-bonds-idUSTRE7295J120110310
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Mr. E Reply:
March 11th, 2011 at 10:51 am
I was shocked when you pointed this out – JG is essentially the Bond Vigilante poster boy. But apparently he is long.
His presentation on U.S. debt from just a few months ago had a very different opinion.
Record Bid to Cover just the other day too…
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Mr. E Reply:
March 11th, 2011 at 12:04 pm
Not only that, but apparently the benchmark that Gross needs to beat is comprised of 30% Treasuries.
A big bond rally would put him far behind his benchmark.
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Geoff Reply:
March 11th, 2011 at 12:11 pm
Gross is well known for talking his book. He is probably talking the bonds down so he can go long, which JG sort of alluded to in the article.
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Ed Rombach Reply:
March 11th, 2011 at 1:21 pm
Did I hear somone say “SHORT COVERING RALLY”? One hot humid day when I was visting NYC from out of town, I got caught in one of those summer thunder storms without an umbrella when it started pouring buckets. Umbrella stands are ubiquitous on the streets of Manhattan so I grabbed the nearest one at hand. The sale price on display was $3 but the guy selling them wanted $5. I complained that the sign said $3, but he countered “Yeah but its pouring rain and the price is going up to $7 soon!” I paid $5 and the experience taught me what it means to be short in a rising market.
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Mario Reply:
March 11th, 2011 at 3:19 pm
yeah. get out where you can when you can…I hear ya there. sellers getting stopped out can help fuel a rally too.
March 11th, 2011 at 9:42 am
Treasury bonds rallied sharply in anticipation of QE2 (i.e. yields dropped), but have since backed off to about where they were before. In other words, QE2 turned out to be a whole lot of nothing.
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Mr. E Reply:
March 11th, 2011 at 10:53 am
Most of the bond selloff late last year was probably due to Gross bailing out of Treasuries. And QEII isn’t over yet.
But Warrens explanation is solid…the feds actions are perhaps too small if they are trying to influence price.
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Arthur Reply:
March 11th, 2011 at 12:25 pm
How can the fed peg two rates with the same quantity (dollars)?
If the Fed tries to keep rates on treasuries low, won’t this prevent it from hitting its peg on the fed funds rate or at least make it difficult? If they didn’t mind Fed Funds being at the zero bound they could, of course, then step up and focus on bringing down Treasuries as well, but I don’t think controlling both on the way up is possible. My understanding is that the Fed/Treasury Accord (1951) was partially based on the realization that the Fed could not target both rates at the same time and that controlling the underlying rate (Fed Funds) was picked as more in line with the Fed’s mandate.
Of course the natural rate of interest is zero so smart public policy would always have the Fed Funds rate at zero. But, given the current flawed paradigm, I think QE is little more than a PR stunt.
Maybe this is Warren’s point and I’m being dense?
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Scott Fullwiler Reply:
March 11th, 2011 at 12:37 pm
The Fed can hit as many targets as it wants as long as it sets bids and asks in those markets. An ask obviously suggests they have some inventory, or in the case of reserves can create them.
Arthur Reply:
March 11th, 2011 at 12:45 pm
But, for example, won’t adding reserves when buying bonds to keep treasury rates low serve to drive down fed funds rate? I would assume this would hold true for any two pegs, unless the underlying peg was zero?
Or, as another example, wouldn’t selling 30 year treasuries drain reserves and serve to drive up rates on shorter terms treasuries? I realize the fed could buy the short term treasuries at the same time, but it would seem to me that the adding of reserevs in buying the short term would offset the effect the Fed, in this example, is trying to have on the 30 year rate. What am I missing?
You guys are the experts. I just want to understand.
Scott Fullwiler Reply:
March 11th, 2011 at 1:04 pm
It would if they didn’t also set a bid/ask in the fed funds market. That was my point. So, you’ve got it right–prior to interest on reserves, they wouldn’t be able to hit a particular tsy rate below the rate the mkt would set and also hit a positive fed funds target.
Arthur Reply:
March 11th, 2011 at 1:11 pm
Ok. Now I get it. Thanks.
So the ability to pay interest on reserves should allow them to set the yield curve on no-credit risk fixed income products the whole way out. And that means that, even if we don’t want the natural rate of interest to be zero, the Fed’s being able to pay interest on reserves really negates the need for Treasury to sell bonds anymore. At this point it’s just about the current outdated legal infastructure and no longer about execution of monetary policy. Right?
Thanks,
Arthur
Ed Rombach Reply:
March 11th, 2011 at 1:23 pm
QE-2 is the Fed doing a rain dance.
Peter D Reply:
March 11th, 2011 at 1:41 pm
Scott, could not the FFR still bid down to zero because of all the agencies trading in reserves but not paid IOR? Like now FFR is 0.14 but IOR is 0.25 (I asked this here) So, if the reserves of these agencies go significantly up, the FFR might approach zero, unless the Fed starts paying them IOR as well, correct?
Scott Fullwiler Reply:
March 11th, 2011 at 1:55 pm
Peter,
Yes, absolutely. That was a shortcoming with how the authority to paying IOR actually occurred. If the Fed were to issue time deposits (don’t think they have the authority to do that, though, at least for now), then they could drain even those.
Neil Wilson Reply:
March 11th, 2011 at 2:02 pm
Is there anywhere significant that still doesn’t pay Interest on Reserves?
If not, then don’t we need some of the descriptions updating with the new reality – if only for clarity.
For example how zero bonds works in an Interest on Reserve world without a drain function.
Most of the referred ones still talk about bond drains.
Scott Fullwiler Reply:
March 11th, 2011 at 2:49 pm
Neil,
You still have to do reserve drains if you don’t set the IOR at the target rate, so there’s not much change except for the US. And I actually did a paper in 2004 or 2005 explaining how the IOR works operationally.
Mario Reply:
March 11th, 2011 at 3:16 pm
great discussion. do you have a link to your paper scott?
Tom Hickey Reply:
March 11th, 2011 at 3:27 pm
Ed QE-2 is the Fed doing a rain dance.
Good one. Set to become a classic. :)
Neil Wilson Reply:
March 11th, 2011 at 4:10 pm
+1 for the paper link Scott.
Thanks
Arthur Reply:
March 11th, 2011 at 4:11 pm
Regarding reserve drains and ior:
If quanity of money is endogenous and Fed is price maker and quanity taker, then isn’t discussion about reserve injection and reserve drain somewhat misleading? By paying ior, the Fed can set a floor on the price at which the interbank market lends reserves.
In a pre-ior world, discussion about injection and drain of reserves is somewhat helpful because it reminds us that the Fed Funds rate is set by open market operations, which look like the exchange of reserevs for a seperate asset class (Warren’s metaphore of checking and savings accounts, I think, better describes what is actually happening).
In an ior world, however, the checking and savings account metaphore is no longer useful. The Fed is always going to make the reserves available because it doesn’t want the fed funds rate to go through the roof and for banks to fail because of lack of liquidity (fed was a liquidity clearinghouse before its hubris made it think it could run the world economy). And ior can always ensure a Fed Funds floor without having to drain assets.
What I’m trying to argue is that discussions about drains and injections don’t matter in an endogenous money system devoted to setting the price of credit and preventing bank failures resulting from liquidity shortage.
Is this incorrect? What am I missing?
Thanks again.
Scott Fullwiler Reply:
March 11th, 2011 at 4:37 pm
The wp version of the paper from 2004 (actually written late that year, though published in 2005) is at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1723589
Another more recent paper (2008), again written pre-IOR, that discusses these issues is at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1658232
Thanks for the interest.
Scott Fullwiler Reply:
March 11th, 2011 at 4:41 pm
Arthur,
As I said, though, you still need reserve drains even with IOR if the IOR rate is below the target rate. Similarly, always need adds if the cb’s lending rate is higher.
Checking and savings account analogy is valid regardless, since IOR and no-IOR refer to essentially to a “demand deposit” account, like equivalent to a checking account (though perhaps earning some interest). Savings account in that analogy is like a time deposit (more like a negotiable one, given the secondary mkt for Tsy’s), which is different from reserves earning IOR.
Good questions!
Best,
Scott
March 11th, 2011 at 12:23 pm
Warren,
great post here. So basically we are right back to where we started before QE2 since it was really all a wash and ineffective (b/c they didn’t go for a price they went for a quantity). Only now people are pissed at the Fed and even more confused about what’s going on.
Therefore couldn’t we say that the Fed created a mini bond bubble at the end of this huge bond run in that they created a fear of inflation (or I guess stagflation) and have now destroyed that fear but none of it was real anyway. Either way where we stand now is still in a dis-inflation/deflationary scenario no? And if so doesn’t it still stand to reason that higher tsy rates would NOT be good for our economy b/c that would lead to higher home loans? I actually wonder though that if home loans were to rise a bit people might actually find them more valuable (the bottom is set) and therefore start getting in while the prices are lower now. Anyone that can buy a home is probably waiting to see what is going to happen next with interest rates and therefore sitting on the sidelines don’t you think? QE2 is probably a good example of how intervention like this probably wasn’t such a hot idea don’t you think?
Cheers!
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March 11th, 2011 at 12:46 pm
With all the chatter about “fiscal responsibility” coming out of congress, assuming something significant comes from it, what do you all think will be the impact on the treasury market? Would it be viewed, correctly or incorrectly, as a strengthening of the dollar and treasuries? Could that be what Gross is waiting on?
If so I could see that as having serious ramifications on commodity prices and the stock market.
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WARREN MOSLER Reply:
March 11th, 2011 at 10:30 pm
yes, it’s all potentially highly deflationary, especially if the saudis let crude fall back another 10% or so
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March 11th, 2011 at 2:46 pm
Here is something interesting:
Banco Central do Brasil: http://www.bcb.gov.br/ingles/FinPub/cap5i.pdf
“It is important to emphasize that net debt balances are calculated
on an accrual basis or, in other words, the appropriation of charges
is recorded pro rata, independently of the occurrence of releases
or reimbursements in the period.
Differently from other countries, one should also cite the fact
that the concept of net debt used in Brazil considers Banco
Centrals financial assets and liabilities and, therefore, includes
the monetary base”
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March 11th, 2011 at 7:12 pm
Warren,
You are buying into the expectations hypothesis — e.g. term premia are constant — hook, line and sinker.
But EH has been refuted in pretty much every empirical study, so how do you differentiate between the two hypothesis:
A) long term rates going up because expected short term rates are going up
B) long term rates going up because the term premia are going up but expected short term rates are not going up.
or even a bit of both?
And in that case, how do you know whether the markets are believing QE or not, just by looking at long term rates?
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Scott Fullwiler Reply:
March 11th, 2011 at 8:49 pm
“e.g. term premia are constant”
You obviously haven’t read much of Warren’s stuff on this if you think that’s what he believes. You can have expectations theory work without having constant term premia, for heaven’s sake.
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RSJ Reply:
March 11th, 2011 at 11:30 pm
By constant, I meant time invariance, not constant across rates. That is the definition of the Expectations Hypothesis, but perhaps the heterodox people have a different version, in which case they shouldn’t use the same name :)
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WARREN MOSLER Reply:
March 11th, 2011 at 10:36 pm
what’s a ‘term premia’ except for a higher rate? default risk? otherwise aren’t A and B close enough for all practical purposes the same?
I was just point out how the belief in what QE does works its want into the term structure of rates as both are driven by beliefs.
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RSJ Reply:
March 11th, 2011 at 11:34 pm
“what’s a ‘term premia’ except for a higher rate? default risk?”
Uh, no. We are talking about risk-free rates here.
“otherwise aren’t A and B close enough for all practical purposes the same?”
Not at all. In one case, you are arguing that long term rates are rising because you think that in the future the CB will raise the OIR and term premium for the longer term rate is constant.
In the latter case, you are arguing that long term rates are rising because the term premium is increasing but the CB will keep the OIR at the current level.
So if you cannot distinguish between A) and B), then you cannot argue that the long term rates are going up because of changes in expectations to the time path of OIR.
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anon Reply:
March 12th, 2011 at 1:42 am
“you are arguing that long term rates are rising because the term premium is increasing but the CB will keep the OIR at the current level”
only somebody who’s read too much academic silliness would argue that
it’s all risk and all around the expected short rate path
RSJ Reply:
March 12th, 2011 at 11:38 am
“it’s all risk and all around the expected short rate path”
That is exactly EH — you need to assume that the term premia are constant so that movements in long rates are due to changes in expected short rates and not changes in the term premium, given the expected short rates. Otherwise your model has no power, as you would be describing changes to long rates as due to changes in the short rate plus another unknown variable that also changes with time. Such a model doesn’t actually describe anything at all.
EH is the mainstream academic silliness — which has been disproven in basically every empirical study, yet to quote Schiller, even though “EH is worthless”, it is impossible to kill because it is just too convenient to believe.
The empirical data violating EH is known as the Campbell-Schiller Paradox, which joins the bond premium paradox and the equity premium paradox and every other paradox when mainstream economics tries to make a prediction. But I was surprised that the heterodox people were swallowing EH whole.
Scott Fullwiler Reply:
March 12th, 2011 at 12:53 pm
“which has been disproven in basically every empirical study”
It’s never been disproven. Only a caricature has been disproven that heterodox don’t believe anyway.
Scott Fullwiler Reply:
March 12th, 2011 at 12:58 pm
Let me say this a different way. Much like anon suggested, NOBODY believes in constant term premia (or at least I’ve never seen someone who seriously does–certainly none of the folks I know do). You don’t need constant term premia for EH to be a driving force of lt risk-free rates. Warren, for example, has always accompanied his EH approach with “technicals” and “supply side” factors. RSJ is setting up a straw man and knocking it down.
RSJ Reply:
March 12th, 2011 at 1:30 pm
Scott,
OK, so you are saying that long term rates are expected short term rates + time invariant term premia + time-varying technicals?
If not, then what are you saying?
More importantly, how would you test this theory? What would be a test that would disprove it?
If you can’t test the theory, then why do you believe it, and what explanatory power does it have?
Btw, you see this all the time. You open a paper and the headline says “stock market falls due to deficit worries” or “stock market rises on X” — but it’s all pretty meaningless, right, unless the statement is backed by a verifiable theory. As you keep adding more fudge terms, unless you can say something quantifiable about each of these terms — and time invariance is pretty damn weak — then you start to lose the ability to test the theory. Then it becomes “just so” stories.
WARREN MOSLER Reply:
March 12th, 2011 at 11:03 pm
it’s not a theory, it’s an identity that the term structure of rates and implied future fed funds settings are the same thing.
Just like the 10 year libor swap rate implies/is equal to where the next 10 years of libor settings are trading (ED futures, convexity adjusted, etc.)
So when the 10 year note goes higher in yield, the implied 3 month forward tsy rates (even though there aren’t any such things traded) all the way out adjust as well as they are expressing the same thing.
call it the theory of addition if you want to call it a theory
So what’s the problem?
Scott Fullwiler Reply:
March 13th, 2011 at 1:00 am
It seems Warren’s been “testing” the “theory” for years and it’s worked pretty well. :)
RSJ Reply:
March 13th, 2011 at 1:18 am
“it’s not a theory, it’s an identity that the term structure of rates and implied future fed funds settings are the same thing.”
It’s not an identity at all. Long term rates are higher than expected future short term rates. They are not equal.
So the theory is that long term rates equal to expected short term rates plus something that you don’t know, can’t predict, and can’t measure. Nice identity.
WARREN MOSLER Reply:
March 13th, 2011 at 8:46 am
so you are saying that if the Jun 2013 eurodollar future (ED) happens to be 99 bid, 99.01 offered, that’s not because of someone’s expectations (which are risk adjusted, of course) plus ‘technical’s as previously described?
And why can’t those ‘technicals’ just as easily be a downward factor as an upward factor?
Why else would that person be bidding and/or offering?
What else is ‘the yield curve’ but the sum of its ‘pieces’ by identity?
RSJ Reply:
March 13th, 2011 at 1:27 am
“It seems Warren’s been “testing” the “theory” for years and it’s worked pretty well. :)”
OK, and I knew a successful hedge fund guy who was a rabid austrian, predicting U.S. insolvency at any moment. And Soros attributes his wealth to his insights about “reflexivity”.
And if you ask both why rates are moving now you will get two different explanations, both authoritative. Warren’s would be a third. Which one do you believe?
RSJ Reply:
March 13th, 2011 at 5:55 pm
Warren, you are assuming that the yield curve in the risk-neutral measure is flat, but this assumption requires time-invariant term premia, which are not observed. In that case, you have a couple of “outs” — variance of beliefs, so what is an arbitrage strategy for one is not an arbitrage strategy for someone else. In fact, each person is assigning their own probabilities to events, no one can believe that there is a risk-neutral measure, everyone could be trying to execute their arbitrage strategy, but if they are credit constrained, the markets might look exactly as they do now. And everyone could be wrong, too.
There are a whole lot of assumptions you can relax, but at the end of the day, you are decomposing something that is known — the long term rates, into multiple variables which are not known, and insisting that only the first of these — expectations of short rates — is responsible for the movement in the long rate. Who could possibly check if you are right, particularly as there is no predictive power and it boils down to guessing what other people think will happen.
WARREN MOSLER Reply:
March 13th, 2011 at 7:43 pm
not sure what you mean about the risk adjusted curve being flat?
the current steep curve *is* a risk adjusted curve.
The curve reflects indifference levels.
Yes, there are credit constraints that prevent borrowing that might otherwise make the curve steeper.
And tsy decisions as to duration alter the curve, as do pension fund regulations and bank regulations.
those are the ‘technicals’ that do matter.
They alter indifference levels of participants.
Also, I’m not saying *only* expectations are responsible for long rates.
I did advance my opinion that they are ‘largely’ responsible for for changes in long rates during the period in question.
I agree there is no way to ‘check’ to see if it is technicals or expectations that alter long rates at any point in time.
But that’s not to say that decomposition as presented can’t help with forecasting.
March 12th, 2011 at 12:15 pm
Edward Harrison has an explanation on QE2 on Naked Capitalism, would be interested in commentary:
http://www.nakedcapitalism.com/2011/03/this-is-how-qe-really-works.html
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anon Reply:
March 12th, 2011 at 2:55 pm
that’s actually quite an interesting article in that he covers the waterfront in terms of theoretical interpretation, including MMT on non government income
so as an article, its somewhat incoherent, but very comprehensive – in other words, standard Harrison
the one reference that’s completely silly is QE as an LLR function – nobody apart from delusional Austrians would seriously believe that
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WARREN MOSLER Reply:
March 12th, 2011 at 11:08 pm
an an austrian who understands mmt would be a far better austrian who could actually be credible.
an austrian isn’t meant to be defined as someone who claims gold standard notions apply to non convertible currency.
my take is an austrian should be someone who argues that fiat currency will tend toward inflation due to the political forces at work, and not due to his misguided notions of monetary operations.
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Mario Reply:
March 13th, 2011 at 4:49 am
interesting points on austrians. why do you say “political forces”?
Also, I’ve been meaning to ask you this…do you think (does MMT think) that agg inflation is a “bad” thing and should be avoided? I tend to think that inflation beyond capacity would actually be wealth creative by its very definition and reveals a superior and growing economy…obviously so long as its stable and not extreme of course.
You know EVERY TIME I tell people that the US is not insolvent and that we can always pay our liabilities, etc. the very first thing they say (if they agree with that at all) is that yes but we’ll have inflation…as if this is a bad thing or something even in our current environment. Why is everyone so anti-inflation? I don’t get it unless of course we say that our wages are not inflating…do you think that’s the case and would ELR help to increase base wages across the board or does it not matter?
You bond traders are a bit beyond my league at least for now. I’ve always thought bond traders were some of the best traders around. Great listening to your discussions…even if I’m always playing catching up!! haha!! ;)
Cheers!
WARREN MOSLER Reply:
March 13th, 2011 at 8:48 am
true, as if demand strong enough to keep unemployment below 9% is necessarily seriously inflationary.
and those same people say that if they all knew that govt wasn’t constrained by revenue they’d conduct highly inflationary policy.
can’t have it both ways-
Mario Reply:
March 13th, 2011 at 2:44 pm
exactly. though I think their argument about unconstrained revenues is still based in a fear of inflation, “we can’t just spend…we’ll have inflation!” something like that. The more I’ve looked at it with people the more I really see that they do not really care about “inflation”…they just DESPISE the thought of “government spending” altogether, so therefore MMT is b.s. and totally destructive…the government (of all things) cannot be allowed to be involved in our economy and economic welfare…what are you thinking!! I think such attitudes are the dead-beat sister to neo-liberal thinking and make for a pretty sinister and inefficient economic outlook when put together. But hey…just my thoughts on it!!
Do you think there’s something to be said for wage rates not rising with inflation and over-time most people are really losing out in real asset holdings? I must say it does seem to appear that way to me and my generation. My parent’s standard (or average) asset holding is far more than my generation’s and we are just as skilled if not more skilled than them…
If so, what do you think can be done to help assist wage inflation stay in parallel with agg inflation over the years assuming a steady clip of inflation (which I think is healthy anyway imho)? Would an ELR do that or some kind of minimum wage law that is based on inflation figures yoy or something? Or would you say it’s not even an issue to start with?
Mario Reply:
March 13th, 2011 at 3:04 pm
like this quote by Keynes I just came across:
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
—John Maynard Keynes, Economic Consequences of Peace
March 13th, 2011 at 1:10 pm
Three different interpretations of QE appear to have emerged from this thread.
1) QE is bad for bonds because it is perceived (rightfully or wrongfully) that QE will lead to inflation down the road. The removal of QE will therefore cause bonds to rally. I believe this is Warren’s view.
2) QE is good for bonds due to the Fed’s demand for them. Increased demand equals higher price. Simple economics.
3) QE has been too small and has had no significant impact on the bond market.
Personally, I think the second interpretation is correct, and best reflects the recent behaviour of the bond market. Bonds did indeed rise in anticipation of QE2, which was well broadcast in advance (the bond market is, of course, forward looking). Similarly, the end of QE2 is also highly anticipated. Everyone already knows it’s coming. The end is nigh! When Ben finally does buy his last bond, it is likely to be quite anti-climactic.
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Mario Reply:
March 13th, 2011 at 2:33 pm
just to clarify your point #2…when you say QE is “good for bonds” do you mean higher bond prices or higher bond rates? B/c I think you mean higher bond prices no? If so how do you explain the lower bond prices since QE started? Isn’t it rather clear that QE essentially failed since bond prices still dropped…now of course there’s the argument which can never really be proved that without QE bonds would have dropped even further…who knows and who cares at least imho.
I am also not sure if is Warren’s view is that bond prices will rally after QE either (Warren confirm this?). I think rather he was saying that QE was basically a wash and has really not done anything to stop dis-inflation/deflation in the economy which is really what the Fed wanted to do with QE by attempting to stop a drop in bond prices (rise in rates) so as to support a more attractive 10 year rate for home loans. I believe this is what he’s saying more than an exact direction in bonds themselves but I don’t know for sure…it’s more about the efficacy of QE and where it leaves us now economically vs a trend in bonds in particular…again Warren confirm this if that’s not accurate.
Regardless I personally think it is very possible that after QE we could see bond rates rise (prices fall) for at least a bit of time simply b/c the market had hit a floor for rates back in late 2010 and was naturally changing direction until QE stepped in and “messed around” with things. This is what Gross was complaining about with QE I believe…now as to why he exited all his positions I don’t know and frankly I don’t really care, b/c I don’t know his books or his strategy and all resources and allocations, etc. It’s all just conjecture and imho doesn’t really matter anyway in terms of trend directions…at least imho.
Therefore, we could potentially see bond rates rise (prices fall) after QE simply as bonds “flush themselves out” if you will even though in actuality we are still in a rather deflationary environment economically at large. Let’s also note that a dip in equities usually corresponds with a rise in bonds for obvious reasons so causation is always a question. Regardless, how a rise in rates will effect the economy I think there are arguments for both sides on that positive/negative…but the possibility of that happening is definitely there at least imho. But I ain’t no bond trader at least yet…these are just my thoughts not yours!!! ;)
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Geoff Reply:
March 13th, 2011 at 3:00 pm
Mario,
I meant good for bonds equals higher prices/lower yields. As I said above, the bond market is a discounting mechanism. QE2 was a given well before the official announcement. Bond prices had already risen significantly. I think bond prices dropped after the announcement in a classic case of “buy on rumor, sell on fact”.
Geoff
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Scott Fullwiler Reply:
March 13th, 2011 at 3:30 pm
Sure, but note that activities in anticipation of QE or the end of QE are essentially expectations of effects on rates, which is not overly distinguishable from Warren’s method aside from his view that inflation is driving the expectations of rates and your view that the Fed’s demand/supply intervention in mkts will drive expectations of rates. Big run-on sentence–hopefully makes some sense.
Mr. E Reply:
March 14th, 2011 at 3:49 pm
“If so how do you explain the lower bond prices since QE started? ”
Bond prices are not lower since QE started. QE started mid December. Long end Bond prices are higher, and bond yields are lower than they were when QE started.
I expect a cash for clunkers effect on bond prices – the weakest holders of bonds are selling to a known buyer today rather than in August or September. This seems to have happened after QE I ended.
http://wp.me/p1b5Ih-iQ
We may be seeing that there are few weak holders of bonds remaining as bond prices seem to want to go higher right now.
The point that Scott makes in his run on sentence is the fed is targeting something that cannot be easily moved – expectations. It doesn’t matter what your view of the price of the curve is because they are all based on some form of expectations. And even worse, both of these expectation based views react to QE by ignoring or even using it as a contra indicator. Am I correct, Scott?
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March 14th, 2011 at 2:02 pm
Warren,
Correct aboyt the expectation of the structure of forward federal funds rate. But there is also another term which is the expectation of the structure of the forward probability of default subject to the perceived leverage/sustainability ratio. in the case of the US with its own soevereign currency, this should be zero but it does not exclude the possibility of political bias and erroneous theoretical estimation!
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WARREN MOSLER Reply:
March 14th, 2011 at 4:26 pm
same as what i call ‘risk adjusted term structure of rates’?
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March 14th, 2011 at 8:38 pm
Yes. Notice that this term can deviate the long term structure from the structure of federal funds rate expectations, frustating the so called expectations channel of the QE mechanism. Furthermore,this spread can make all the difference in term structure slopes especially in economies where public debt is not denominated in their sovereign currency!
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March 22nd, 2011 at 2:10 am
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