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June 09, 2005

A Short Dialogue on the Price of the Long Treasury Bond

Alan Greenspan says:

FRB: Speech, Greenspan--Central Bank panel discussion--June 6, 2005 : The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent. The yield on ten-year Treasury notes currently is at about 4 percent, 80 basis points less than its level of a year ago.... The unusual behavior of long-term rates first became apparent almost a year ago.... [W]hat are those forces? Clearly, they are not operating solely in the United States.... A number of hypotheses have been offered as explanations of this remarkable worldwide environment of low long-term interest rates.

One prominent hypothesis is that the markets are signaling economic weakness....

A second hypothesis involves the behavior of pension funds.... But world demographic trends are hardly news, and recent adjustments to funding shortfalls do not seem large enough to be more than a small part of a complete explanation.

The heavy accumulation of U.S. Treasury obligations by foreign monetary authorities is yet another hypothesis.... But, given the depth of the market for long-term Treasury instruments, the Federal Reserve Board staff estimates that the effect of foreign official purchases has been modest....

A final hypothesis takes as its starting point the breakup of the Soviet Union and the integration of China and India into the global trading market.... The enlargement of global markets for goods, services, and finance has contributed importantly to the favorable inflation performance that we are witnessing in so many countries. That improved performance has doubtless contributed to lower inflation-related risk premiums, and the lowering of these premiums is reflected in significant declines in nominal and real long-term rates. Although this explanation contributes to an understanding of the past decade, I do not believe it explains the decline of long-term interest rates over the past year despite rising short-term rates....

[L]ow risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk.... The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors.... I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked.... [C]ontinuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing....

Admetos: I'm not sure I understand what Greenspan is saying. What academic model do you think he is relying on?

Thrasymakhos: You think Greenspan relies on economic models? Whoo boy, do you have a lot to learn!

Admetos: What important economic forces does he think are at work?

Thrasymakhos: You're asking me? I'm just a cardboard cut-out--a literary fiction--a stand-in for the author who says cynical things that the author does not quite say in his proper persona.

Glaukon: Greenspan mentions four factors--pessimism, demography, Asian central bank purchases, and global integration--and says that none of them account for the strange behavior of long-term interest rates.

Thrasymakhos: He does.

Glaukon: He then goes on to talk about a fifth factor--hedge funds chasing yields that "seek above-average returns... risks... trading strategies destined to prove disappointing." But he does not say that they are responsible.

Thrasymakhos: He does not.

Glaukon: But he does not say that they are not responsible either. Can we infer from his silence that he believes that they are responsible?

Thrasymakhos: He's named Alan Greenspan, not Leo Strauss.

Glaukon: Nevertheless, it is an interesting idea. How would it work out?

Khrematistikos: Let rT be the interest rate on long-term Treasury bonds, and let r be the interest rate on short-term cash. Consider a hedge fund that believes that bond prices will not move by much in the near future--or that, if bond prices do move, its location in Manhattan and the quick fingers at the keyboards of its traders will let it be one of the first out the door. Let R be the rate of return target of the hedge fund. And let L be the leverage of the hedge fund--the amount of dollars per dollar of capital that it borrows short in order to engage in the carry trade. Am I clear?

Sokrates: Clear as daylight, Khrematistikos.

Khrematistikos: Then the relationship between these variables for this hedge fund is:

R = L(rT - r)

Which tells us that the hedge fund's demand for long-term Treasuries (and its supply of short-term cash) is:

L = R/(rT - r)

Is everybody with me?

Glaukon: We are, Khrematistikos.

Khrematistikos: Now what happens when the Federal Reserve raises short-term interest rates r? That narrows spreads between short- and long-term interest rates, and induces the hedge fund to increase its demand L for long-term Treasuries. That means that increases in short-term rates are associated with increased demand--higher prices--lower interest rates--on long-term bonds. In other words, hedge-fund demand for long-term Treasuries slopes the wrong way: when prices rise, demand does not fall but increases.

Admetos: And?

Thrasymakhos: And when Treasury prices start to fall, hedge-fund demand for securities will fall too. Falling prices do not reduce excess supply but produce an even bigger excess supply.

Admetos: That doesn't sound good.

Thrasymakhos: Indeed, it is not. Big air pockets. Large price declines. Financial panic.

Glaukon: Is this a scenario to worry about?

Thrasymakhos: How would I know? Do I look like New York Federal Reserve President Tim Geithner?

Posted by DeLong at June 9, 2005 07:29 PM