July 22, 2003

Panic in the Bond Market?

Morgan Stanley's Stephen Roach sees a bond-market panic driven by depressed "animal spirits" on the part of bond traders. The Federal Reserve needs to keep long-term interest rates low to spur investment and recovery. How it can do this if it is indeed the case that long-term bond interest rates are now being set by panicked traders rather than forward-looking economists is a mystery:

Morgan Stanley: ...There are a number of alternative explanations to this dramatic sell-off in the bond market.† There are those, of course, who claim that signs of incipient economic recovery have turned the bond market inside out.† While I'm hardly objective on that point, even the diehard growth optimists concede that the evidence remains mixed at this point and that the vigorous recovery call is still a forecast (see Dick Bernerís July 18 dispatch, "Recovery Signs").† Others have argued that the rapidly deteriorating federal budget deficit is the culprit, sparked by the administrationís midyear confession that the budget shortfall is likely to hit $455 billion in the current fiscal year.† While I would be the last to minimize the significance of this development, it hardly qualifies as the singular surprise that can explain the bond marketís extreme gyrations over the past few weeks.† In my view, this sell-off has the fingerprints of the Fed all over it.† Maybe it's all a coincidence that this chain of events unfolded at the same time that Fedspeak reversed course.† But I doubt it.† †

As to where the bond market goes from here, my advice is to ignore the economists and listen to the traders.† Itís been my experience that huge market moves like this have little to do with fundamentals and much more to do with market technicals and trading dynamics.† The very concept of "fair value" is utterly meaningless at times like this.† I am still scarred by my futile efforts to make sense of the bond market carnage of 1994.† Even so, I canít help but note that long-term real interest rates of 2.2% (as measured by the 10-year TIPS) are still well below average (3.5%) for a recovering economy with outsize budget deficits.† In other words, if Iíve got the recovery bet wrong, even the economics suggests that thereís still plenty of upside to yields from current levels.†

But hereís where I defer to the traders.† Their tone is starting to sound very similar to that which was evident some nine years ago.† As was the case back then, thereís great concern today over selling pressures stemming from mortgage "convexity."† And yet todayís US economy is actually far more dependent on the infrastructure of home mortgage financing and refinancing than it was in 1994.† According to Federal Reserve data, mortgage debt outstanding is currently about 67% of GDP; by contrast, in 1994, the ratio was 48%.† If anything, that suggests there could be an even more powerful convexity-related unwind this time around.† The traders today are telling us exactly what they did back then -- the more rates back up, the more the long end gets hammered by an unwinding of mortgage-related hedging.† Itís a warning we have to take seriously.†

But thatís not all.† One of my most seasoned trader compatriots has always warned that a yield curve which "steepens in a downtrade" is emblematic of the most virulent of bear markets.† And thatís exactly what is going on today.† The spread between 2s and 10s in the Treasury market hit 259 bp at the close on 21 July -- equaling the yield gap last seen in 1992.† The traders are telling me that this "bear spasm" is now at risk of feeding on itself -- until or unless it is stopped by an unexpected weakening in the economy or by direct intervention by the authorities.†

This is hardly an outcome that the Fed, or any of us, would deem desirable in the current climate.† It runs the very real risk of spilling over into other asset markets -- especially given the mounting potential for an a further sell-off in the US dollar as part and parcel of Americaís long overdue current-account adjustment.† Moreover, a sharp additional back-up in long rates poses a serious threat to a nascent recovery in the US economy -- not only crimping the credit-sensitive sectors of homebuilding, capital spending, and consumer durables but also aborting the home mortgage refinancing cycle that has been so supportive of consumer demand.† We tend to forget that the US economy is still closer to the brink of deflation than inflation.† Wouldnít it be ironic -- and tragic -- if the perils of deflation were compounded by a rout in the bond market?...

Posted by DeLong at July 22, 2003 12:53 PM | TrackBack


Remember, Alan Blinder told us a month ago that there was a bubble in the bond market. Who would hold a 10 year treasury at 3.11%? The recovery may well continue to be weak, but buying bonds, especially treasuries, at the levels of June 13 would be absurd.

Posted by: anne on July 22, 2003 01:13 PM

There really does seem to be an asset "bubble." While 10 year treasuries were at 3.1% in June, the price earning ratio for the S&P was at 30 then and is at 32 now. The price earning ratio for the NASDAQ is comical. There has also been a sharp rise in home prices in many areas.

Merrill Lynch told investors yesterday that the stock market was priced not for recovery but for "boom."

Posted by: anne on July 22, 2003 01:23 PM

Could it be that the bond market reaction finally begins to reflect the realities of low private saving, government deficits, and balance of payments deficits?

Posted by: jd on July 22, 2003 01:30 PM

If I understand correctly, the consensus is that expected returns from stocks, bonds and cash are very low, if not negative. Not much to cheer an investor.

Posted by: richard on July 22, 2003 01:32 PM

Americans, especially in older households, are net creditors. Interest income is important for them. These very low interest rates are a significant problem. Alan Greenspan shrugs off the problem, but I worry. Could the mix of tax cuts of little stimulus effect and low interest rates have forced the Fed to lower rates too much?

Posted by: anne on July 22, 2003 01:40 PM

>"forward-looking economists", Brad?

(Isn't that an oxymoron? SURE it is. In fact, it's a "classic" ;!)

Main Causes of the Great Depression

Paul Alexander Gusmorino 3rd : May 13, 1996

The Great Depression was the worst economic slump ever in U.S. history, and one which spread to virtually all of the industrialized world. The depression began in late 1929 and lasted for about a decade. Many factors played a role in bringing about the depression; however, the main cause for the Great Depression was the combination of the greatly unequal distribution of wealth throughout the 1920's, and the extensive stock market speculation that took place during the latter part that same decade. The maldistribution of wealth in the 1920's existed on many levels. Money was distributed disparately between the rich and the middle-class, between industry and agriculture within the United States, and between the U.S. and Europe. This imbalance of wealth created an unstable economy. The excessive speculation in the late 1920's kept the stock market artificially high, but eventually lead to large market crashes. These market crashes, combined with the maldistribution of wealth, caused the American economy to capsize...


Interim Report: Notes on the U.S. Trade and Balance of Payments Deficits

Wynne Godley


1 The United States has a balance of payments deficit worth nearly 4 percent of GDP and negative net foreign assets (or foreign debt) worth nearly 20 percent of GDP. If U.S. growth is sustained in the medium term, it is quite likely that the balance of trade in goods and services will not improve. The United States is the only major country, or country "bloc," to have a substantial trade deficit and this is proving of great advantage to the rest of the world.

2 If the balance of trade does not improve, there is a danger that over a period of time the United States will find itself in a "debt trap," with an accelerating deterioration both in its net foreign asset position and in its overall current balance of payments (as net income paid abroad starts to explode). Such a trap would call imperatively for corrective action if it is not at some stage to unravel chaotically...."


Why Deficits Matter

Sunday, July 20, 2003; Page B06

WHEN BUSH ADMINISTRATION officials discuss the deficit, they make it sound like a problem on the scale of a particularly persistent case of fiscal dandruff. "Manageable," Office of Management and Budget Director Joshua B. Bolten told a House hearing. "A concern," the chairman of the Council of Economic Advisers, N. Gregory Mankiw, wrote in The Post. Treasury Secretary John W. Snow ventured about as far out as any administration official, but he left the country to do it, telling a London audience that the new deficit numbers were "worrisome..."


As Budget Deficit Grows, Greenspan Speaks Softly

By Jonathan Weisman and John M. Berry
Washington Post Staff Writers
Sunday, July 20, 2003; Page A01

The White House had just released its forecast of the highest U.S. budget deficit ever, but Federal Reserve Chairman Alan Greenspan was not about to be pulled into a blame game. Yes, Greenspan told a House panel on Wednesday, deficits are bad, but then again so is some government spending, and tax cuts can be quite good but only if made judiciously.

"I would prefer to find the situation in which spending was constrained, the economy was growing, and that tax cuts were capable of being initiated without creating fiscal problems," Greenspan said.

"I would prefer a world in which Julia Roberts was calling me," replied an exasperated Rep. Bradley J. Sherman (D-Calif.), "but that is not likely to occur..."


Posted by: Mike on July 22, 2003 01:47 PM

The L-Curve

By David Chandler

The income distribution of the United States

Consider this picture:

Imagine the population of the United States stretched across a football field in order of income, from poorest to richest. Now imagine a stack of $100 bills representing each person's income. (A 1-inch stack of $100 bills is $25,000.) The red line represents the heights of those stacks compared to a football field. I call this graph the "L-Curve."

Here is the top of the "L-Curve". Ordinary millionaires don't even show up! (One pixel on the vertical scale of this picture represents $250 million.) $1 billion is a a stack of $100 bills 1-kilometer (0.6 miles) high. Bill Gates' wealth increased from about $50 billion to $100 billion in one year recently, so in that year he had an income of at least $50 billion*. Bill Gates, personally, is not the point. He is one of (currently) hundreds of billionaires in this country who happens to have particularly high name recognition.

The graph illustrated in these two pictures represents income, not wealth. The distribution of wealth is even more skewed...

...I am not an economist, but then again, most likely you aren't either. On the other hand, we both have the vote and need to come to grips with these issues to participate intelligently in the political process. There needs to be a genuine national dialog on these issues at all levels.

Think of the L-Curve when you read your daily news. What are its implications for tax structures, campaign finance reform, the IMF and WTO, abandonment of inner cities, factory closings, sweatshop labor, "guest worker" programs, US foreign policy, why we go to war, etc. How does welfare for the poor stack up against corporate welfare?

Should the goal be to get motivated and get yourself onto the vertical spike? Some people who have responded to this site see it this way, but I think that misses the point. I saw a bumper sticker recently that says it for me, at least:

[Graphic: "EVERYONE does better when EVRYONE does better"]

Our economy produces tremendous wealth but it also produces tremendous poverty. It is a systemic, not an individual problem. There is plenty to go around, but it doesn't adequately go around. It goes to the top, and leaves the masses to fight over the crumbs. True, it has been this way through the ages, but that doesn't mean we should be satisfied with such a system. I believe we can do better.

Some doctors and lawyers and professional people, with incomes of a few hundred thousand dollars may feel "rich". They may have nicer homes and cars, and they may have attitudes that separate them from the masses. But they still must work for a living and are primarily consumers of their earnings. Whether they recognize it or not, they actually have more in common with the people at the bottom than they do with the people in the top 1/2%.

The horizontal spike has the votes. The vertical spike has the money. Who wins, when it comes to electoral politics? Who has influence? Whose interests are being represented in Washington? Can democracy meaningfully exist where the distribution of wealth, and thus the distribution of power, is this concentrated?

We recently went through an economic boom where people on the horizontal spike showed little if any improvement in their condition while those in the vertical spike showed huge gains. Can this be considered "prosperity"? Do we really want to gear up our national policies to repeat this performance?

Those in the vertical spike would like to have you resent the poor who are portrayed as welfare leeches. Which group actually has a bigger negative impact on your lifestyle: the people in the bottom half of the graph, or the people in the vertical spike?

Is the vertical spike just Bill Gates? NO. In 1997 over 144,000 tax returns were filed with adjusted gross incomes of $1 million or more. As the vertical spike rises it thins down to a few individuals, but there is a growing class of billionaires that collectively holds a substantial fraction of the wealth of the country.

People on the vertical spike can use their influence single-mindedly and very effectively. A single billionaire can get the undivided attention of any politician he wants, any time he wants. If he doesn't get what he wants he can, in fact, "fight city hall," the statehouse, and the federal government. People on the horizontal spike must pool their limited individual power and organize to have any effect at all. This is a very difficult thing to manage, in practice.

The mainstream media has been bought up by the people in the "vertical spike." The primary channels for information and expressed opinion are controlled and filtered by a small, powerful group on the vertical spike whose interests are not representative of the majority of Americans. Even when there is no direct political message the programming is tailored to the perspectives and sensitivities of large corporations. The business of media is to sell advertising. Programming is simply the hook to hold an audience until the next commercial. Serious examination of ideas of any kind is seen as counterproductive because it may alienate or bore part of the potential audience. The result is non-stop sensationalistic binges of O.J., Princess Di, Monica, and Elian. The growing media monopoly dilutes and distorts the national dialog, and thereby destroys the basis for democracy. We must find ways to rebuild community and learn to talk to each other directly.

When taxes are cut, whose taxes are cut and whose programs are cut? What kinds of taxes are being cut and what kinds of taxes (whether they are called taxes or not) are being imposed? Sales tax and use fees tax primarily the horizontal spike. The pre-Reagan progressive income tax drew more from the vertical spike. The flat tax would shift the burden downscale even more. The sales pitch for this shift usually focuses on "simplification." Simplification is unrelated to the issue of where the money is coming from. The proposal to eliminate the income tax entirely would be disastrous. The vertical spike would thereby escape virtually all of its tax obligations and the burden would be born almost entirely by the horizontal spike, both through increases in other forms of taxation and reduced services. The income tax originally taxed ONLY the vertical spike. This is the direction tax reform needs to take if it is to be truly considered "reform."

Can the people on the horizontal spike take control of their own destinies and truly make this a nation governed in the best interests of the people? If so, how?

Is the L-Curve "good" or "natural" or "inevitable"? What are the alternatives? The economy is a complex system, but it is essentially a human invention. It can be "managed" (or influenced) in many ways. If it is not managed intentionally, then it is managed (or manipulated) by those who hold political and economic power, typically to their own advantage. It is not enough to create a strong economy. It is just as important to ask how the benefits of the economy are distributed through the population. A truly democratic society needs to find ways to manage the economy to benefit the population as a whole. This is not being done."


Posted by: Mike on July 22, 2003 02:18 PM

Mike, you're still lost with all of the answers. Try taking a few more classes. You aren't doing as well on coherency as you seem to think you are. Your answers usually have nothing to do with the question.

Posted by: Stan on July 22, 2003 02:33 PM

>> Could it be that the bond market
>> reaction finally begins to reflect
>> the realities of low private saving,
>> government deficits, and balance of
>> payments deficits?

Right -- which would leave us with the perennial question asked of all asset markets: Why did it take so goddamn long?

Posted by: P O'Neill on July 22, 2003 02:35 PM

Oh poor Mikey. Haven't the little green men in flying saucers come for you yet. Try ranting with your voice they may hear you better than and finally come take you away, plus you will also save Prof. DeLong's bandwidth, others' posts and everyone's sanity.

Posted by: achilles on July 22, 2003 02:45 PM

Mike, quit with the ten thousand word posts. Just give the links and keep it relatively short. Or get your own blog.

Posted by: Gideon S on July 22, 2003 02:48 PM

Okay - stupid observations here -

I can sort of understand the bond sell-off, but I can't understand where this will take us. In other words, I'm not sure where these traders intend to put their money.

I have been resisting the signs that point to another "great depression"-like fall, but I'm beginning to think we may be seeing just that.

Does anyone else think we're on the brink of what could be a VERY VERY ugly economic meltdown? Is Paul Krugman right?

Posted by: SZ on July 22, 2003 03:01 PM

>Stan on July 22, 2003 02:33 PM

>"Mike, you're still lost with all of the answers...

>achilles on July 22, 2003 02:45 PM

>"Oh poor Mikey...

Well guys, at least I'm in good company. It's not like this stuff is "rocket science" or anything.

Hell, better men than you two have understood the problem AND its consequences since the industrial revolution first stood up on its hind legs...

"I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country. . . . corporations have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed."

-- U.S. President Abraham Lincoln, Nov. 21, 1864
(letter to Col. William F. Elkins)

And they have TRIED to explain all of this stuff to guys like you two again, and again...

The Economic Consequences of the Peace

by John Maynard Keynes


Why SOME people STILL don't seem to "get it" after all these years, and bubbles, and crashes, and wars is beyond me.....

Posted by: Mike on July 22, 2003 03:02 PM

>Posted by Gideon S at July 22, 2003 02:48 PM

>Mike, quit with the ten thousand word posts. Just give the links and keep it relatively short. Or get your own blog.

(Is it my turn ;?)

Hey bubba G? Are you the boss of me? I don't THINK so.

Here's a "friendly suggestion" from me to you:

Mind your OWN damned business. It's really not so hard. Once you get used to it...

Posted by: Mike on July 22, 2003 03:17 PM

? what does "morgage "Convexity"" mean.

Posted by: big al on July 22, 2003 04:03 PM

Roach must really know he has made it in the world when he makes DeLong's weblog! Has Roach of the Wildnerness heard "The dirty little secret that neither party wants to talk about"?


The Congressional Budget Office said last month the 2003 deficit would top $400 billion, catching up with private-sector forecasts.

As a share of the economy, the 2003 and 2004 deficits represent 4.2 percent of gross domestic product, below the record 6 percent registered in 1983. If everything goes according to Hoyle, with GDP growing at the administration's projected 2.8 percent in this calendar year and 3.7 percent in 2004, the 2006 deficit would represent 1.9 percent of GDP.

Growth Matters

Just to give you an idea of how important economic growth is in the equation, if the economy grows at 2 percent rather than 3.7 percent, the deficit could easily balloon to $600 billion next year, according to Chris Wiegand, an economist at Citigroup Inc.


The dirty little secret that neither party wants to talk about is that President George W. Bush is a big spender. Stripping out the increase in national defense outlays, discretionary spending, which is dictated by 13 annual appropriation bills, rose 12.3 percent in fiscal 2002 and will rise 12.6 percent in 2003, according to Veronique de Rugy, a fiscal policy analyst at the Cato Institute, a libertarian think tank in Washington.

Discretionary spending does not include things like unemployment insurance and food stamps, which along with Social Security and Medicare are mandatory and which always rise when the economy is weak.

Son Beats Dad

Bush's three-year track record for real non-defense discretionary spending in inflation-adjusted terms shows a cumulative 20.8 increase, exceeding the first three years of Bush I (up 11.6 percent) and the full four-year terms of Jimmy Carter (up 13.8 percent), Ronald Reagan (down 13.5 percent in the first term and down 3.2 percent in the second), Bill Clinton (down 0.7 percent and up 8.2 percent), according to de Rugy.

Posted by: Faith Witryol on July 22, 2003 04:12 PM

A good background paper on convexity is here:

How credible was (or is) the Fed claim to be able to meaningfully intervene as a purchaser of long term securities? It seems to me to be meaningful as talk (so-called jawboning) to bring long term real interest rates lower, temporarily - but could it actually do what it repeatedly claimed to be able to do? If not, then what?

Posted by: Eric Glynn on July 22, 2003 05:07 PM

Sorry - that convexity link is:


Posted by: Eric Glynn on July 22, 2003 05:12 PM

I believe that bonds were (and are) overpriced, but I think the proximate cause of the fall was a change in perception regarding the likelihood of unconventional (outside shifting the funds rate) actions to support the bond market as a result of the first day of Greenspan's testimony. Belief that such actions were possible encouraged bond buying at unreasonable prices.

Now that bonds are falling, the need to unwind positions that were basically entered into as hedges can create a situation where the selling feeds upon itself. No telling how far it can go, but it isn't likely to stop with bonds still significantly above what most people would say is a fundamentally justified price.

Posted by: matthew wilbert on July 22, 2003 06:00 PM

Matthew -

But was that belief that such unconventional actions were possible and on the Fed's horizon justifiable, in your view?

Posted by: Eric Glynn on July 22, 2003 06:58 PM

Can someone give me a nice run down on how and why this will effect the housing market? What are the lags? How direct, specifically, are the effects, etc.

Posted by: theCoach on July 22, 2003 08:22 PM

The yield on 10-year Treasuries at the end of cash trade Tuesday was just 21 bp above the closing yield on May 5, the day before the Fed let on that it might confront and "unwelcomed slowing in inflation" by buying Treasury coupons. A quick look at a 10-year yield chart sure makes it look as if most of the rise in yields that has caught Roach's (and pretty much everybody else's) attention simply accomplished the correction of a mistake in pricing, based on a mistake in transmission of policy intentions by the Fed. Now that that particular mispricing has been taken care of, the 2 questions Roach presents are whether there is further mispricing (real 10-year rates of 2.2% vs the 3.5% that Roach offers as "average"), and whether there will be overshoot to the upside in yields. Roach righly points to the current account when discussing the potential for overshoot - changes in price don't happen in a vacuum - but anticipation of current account disaster has been with us for some time without the disaster itself. I don't doubt there will be some overshoot - cyclical turns in the bond market do tend to overshoot. But overshoot has to be defined around some price. Yields have to dip back to a "reasonable" longer-term average to declare that an overshoot has occurred. If that average proves to be 4.50% rather than the 5.40% or so that Roach's math suggests, then the overshoot won't be all that damaging. Beyond that, if we do go back to what Roach suggests is "average", why is that so bad? Roach is describing an average real 10-year yield during periods of growth, recovery after recession.

Let's consider another problem that often shows up in discussions here. There ain't no jobs. As long as there ain't no jobs, why should there be an expectation of sufficient growth to push Treasury yields a lot higher?

Posted by: K Harris on July 23, 2003 05:24 AM

Couple of things to note about market conditions now, that may help in understanding short-term moves in long-end rates. The put/call ratio on 10s is at 14 - there are 14 times as many puts held now as calls. That means lots of people have hedged against the possibility of rising rates. That amount of hedging should prevent panic selling if rates rise. Mortgage convexity models probably have 4.25% on 10s as a tipping point, because there was a flood of refinancing on the break of 4.25% on the way down. If 4.25% is approached, there may be a pick-up in hedges being shed - Roach's convexity worry. On the break of 4.25%, Roach's worry could become a bit fo a nightmare, in the short term.

Posted by: K Harris on July 23, 2003 05:38 AM

This coming year, American public and private saving will become zero or turn negative. This will insure severe pressure on the balance of payments. Will this generate a crisis? I have no idea, especially since Asian economies have an important interest in keep the value of the dollar stable. Still, this is not a desirable situation and may presents severe problems at any time.


Posted by: anne on July 23, 2003 12:32 PM

So, the facts to be explained are that short term rates are falling, but long term rates are rising. Isn't that what normally happens when current monetary policy is inflationary? Is the cult of Alan really so strong that we have to resort to this shocking blah about "steepening downtrades", "convexity hedging" and so forth and so on, rather than just consider the possibility that the Fed might have taken its eye off the ball?

Posted by: dsquared on July 23, 2003 11:32 PM


I thought that the point being made was that in the absence of GDP growth and disinflation that the rise in long term rates was an additional deflationary pressure?

In any case I wouldn't be so quick to dismiss the "L-curve." If my understanding is correct we are in disinflationary conditions with a weak consumer demand and significant unused capicity, are we not?

In these conditions, does it not bear to consider that the massively skewed distribution of wealth places much of it in the hands of those who primarily invest while the rest primarily consume? Does it not lead one to consider that investment in debt instruments at this point is potentially counter productive (since there is already too much capacity) and this money would be put to better economic use in the hands of consumers so as to boost aggregate demand? I'm not saying this is necessarily so, however the idea is worth considering, is it not?

Posted by: Lorenzo on July 24, 2003 07:17 AM

By the logic of the "shocking blah" analysis, Fed policy was too tight from early May to mid-June (when the curve flattened), then suddenly became too easy, risking inflation. Another possibility is that it isn't shocking blah. Rather, as Roach suggests, there really are technical factors, such as mortgage portfolios lifting hedges, that are working to steepen the curve. A look at the recent pace of refinancing suggests that mortgage portfolios have had an enormous incentive to hedge against mortgages being called, probably the strongest incentive ever, an incentive that has rapidly diminished as ten-year rates rise.

An argument similar to the view that monetary policy is outright inflationary is that conditions in the economy are less disinflationary than was thought. It is not necessary to make somebody else (like Greenspan or Roach) out to be badly mistaken in their thinking (no matter how much fun that may be) to reach the conclusion that recent steepening has been driven partly by changing inflationary expectations, if the change is from "unwelcome" disinflation to a happier state of inflationary affairs.

Greenspan, with Poole and Bernanke right behind him, have made the point that the Fed is less likely to mess about with the long end of the Treasury curve than had been assumed after the May 6 FOMC announcement. That, too, could have resulted in a shift in the curve.

Posted by: K Harris on July 24, 2003 07:27 AM
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