Greenpan’s conundrum I

I thought I had enough of Greenspan’s conundrum with all the litter
I spilled the other day at JD Hamilton’s excellent yield curve presentation.

But, I was drawn in once again by reading knzn’s CB bank bond and US
interest rates purchases presentation
, at his well argued
blog: Economics and.

In his post, knzn cautions singling out foreign CBs as being the
sole culprits of lowering long term rates; I tend to agree that a
deeper look is worthwhile—there may well be other forces at work that
are being overlooked.

In his own words:

So intervention by China (or Japan or Saudi Arabia or wherever)
does have the net effect of reducing US interest rates. At any
particular time, though, the effect of such intervention is likely to
be swamped by the effects of other business cycle phenomena.

Although, any respectable Hayek follower would find this statement
amusing—aren’t CBs the ones that start rocking the boat of the
business cycle in the first place?

Anyhow, I’ll try to deliver here a recount as clearly as I can of my
own thoughts—and those of some wiser minds. If for no other reason than
trying to get a better grip on a perceived pivot point in world
markets, which I need to expose to guide my trading.

And then, could we be heading ourselves into a recession?

First, let’s take a good long look at the yield curves up until February 2005; to which we owe Mr. Greenspan’s
remarks regarding a conundrum in his 16 February 2005 report to

Source: US Treasury

And, what’s wrong with these curves?

Plainly put, the slopes are gradually and disquietingly shifting into a descending slope pattern, which would normally elicit slower growth expectations in the horizon. After 7 Fed rate hikes, the long-term end is declining, not rising as expected—a conundrum.

In his own words, here’s the part where Mr. Greenspan describes the conundrum:

All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and an associated greater willingness to bear risk than is yet evident among business managers.

Both realized and option-implied measures of uncertainty in equity and fixed-income markets have declined markedly over recent months to quite low levels. Credit spreads, read from corporate bond yields and credit default swap premiums, have continued to narrow amid widespread signs of an improvement in corporate credit quality, including notable drops in corporate bond defaults and debt ratings downgrades. Moreover, recent surveys suggest that bank lending officers have further eased standards and terms on business loans, and anecdotal reports suggest that securities dealers and other market-makers appear quite willing to commit capital in providing market liquidity.

In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations.

Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields.

But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German ten-year Bund rate, for example, has declined from 4-1/4 percent last June to current levels of 3-1/2 percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels.

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world’s productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world’s pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.

Mr. Greenspan apparently believes that the excessive demand for longer-term bonds is an anomaly, which may correct itself in the short term—not necessarily hindering future growth. A possible exception, where the usual expectations of an inverted yield curve, of increasing the probabilities of a recession, would not necessarily apply… because he is unable to explain the broadly unanticipated behavior of world bond markets—the conundrum.

Second, let’s revisit some basic economic facts, so, we get a good solid footing on the matter—at least, I need to do so.

If an investor is confident in future growth, he expects to get paid a better return for a longer-term deposit. He’s not only forfeiting the convenience of spending his deposit for a longer period; but, it’s also riskier, his deposit is away from his own caring eyes for a lengthier period of time, who knows?  On the other side of this coin, a business borrower has more tendency to commit himself in the long term, if his prospects are good.

If an investor is not confident in future growth, or he feels that rates will fall in the near future, he may be willing to forgo a higher short-term deposit return, in order, to lock-in longer-term yields. Whilst, if a business borrower is not
confident of future prospects, he will avoid taking long-term loans.

If we look under the hood of this yield rate, we find that it’s composed of two parts: the real interest rate plus inflation.

If an investor expects inflation to rise he will further ask for a higher return on his deposit too. But, if he expects the opposite, deflation, then he will be willing to take a lower return on his longer-term deposit to lock in its present yield.

Also, we must consider volatility of both real interest and inflation. Obviously, the greater the volatility, the greater the premium an investor would ask to add to his return; and vice versa.

On another footing, we also have to take a closer look at the potential arbitrage carry-trades involved; these few come to mind:

  • If the yield curve inverts, then borrowing the longer-term to lend the shorter-term is sensible and profitable; a term carry-trade. This carry-play underscores the aberration of an inverted yield curve, what could possibly counter this very strong play? Deflation, of course.
  • If yields lower, debtor’s refinancing would also make sense; another yield carry-trade.
  • Borrowing from a low yield falling currency and lending to a higher yield rising currency; a currency carry-trade. Borrowing JPY to lend USD, used to be quite  profitable for a while.

Third, now that we’ve covered the basics of the yield curve, let’s turn to Ben Bernanke’s saving’s glut explanation of the conundrum.

Here are his remarks at The Homer Jones Lecture on 14 April 2005; which he summarizes in the following paragraph:

I have presented today a somewhat unconventional explanation of the
high and rising U.S. current account deficit. That explanation holds
that one of the factors driving recent developments in the U.S. current
account has been the very substantial shift in the current accounts of
developing and emerging-market nations, a shift that has transformed
these countries from net borrowers on international capital markets to
large net lenders. This shift by developing nations, together with the
high saving propensities of Germany, Japan, and some other major
industrial nations, has resulted in a global saving glut. This
increased supply of saving boosted U.S. equity values during the period
of the stock market boom and helped to increase U.S. home values during
the more recent period, as a consequence lowering U.S. national saving
and contributing to the nation’s rising current account deficit.

I would say that this is a good description of the situation, albeit incomplete. I think he missed the main issue when he explained the dog’s tail out of the discussion—or the trade issue.

In my opinion, Greenspan’s argument of the gradual incorporation to the world markets of the populations of the broken down Soviet Union, plus China and India—approximately 3 billion; as having a profound effect in lowering worldwide manufacturing costs, hence world inflation, is at the root of explaining the US current account deficit problem.

I was saving this chart for later on…


Source: Federal Reserve Bank of Cleveland
Data provided by LABORSTA

But in it, you can appreciate the enormous drop in inflation that the
world has experienced in recent years, from the 32 % during 1994 down to
4 % nowadays:

Once the trade imbalance is established due to low manufacturing costs in emerging countries, which may be aggravated by CB intervention to avoid the natural rise of the local currency, then and only then, will surpluses and deficits occur—solely through mercantile forces at work.

Furthermore, the savings glut is enlarged because business investment has become riskier worldwide, which is also based in mercantilism. Low wage areas are riskier (non democratic governments, greater barriers to repatriate investment; i.e, China). But, they are also crowding out investors to other less preferred areas with higher wages in developing countries, which makes goods pricier, less competitive worldwide; hence, also a riskier investment.

An interesting sideline effect has been that commodity prices have risen. If deflation has been the norm for many years, then, lower priced goods have induced a greater demand for themselves—and consequently a greater demand for the commodities required to manufacture them.

It can also be argued that the proof that emerging country workers are benefiting from their incorporation to world markets is that there is a great need for building infrastructure at these locations, which in turn demands greater amounts of commodities, such as: copper, cement, iron ore, and ….oil.

And a greater demand for commodities is another source of surpluses; as we all know, prices in commodities have sky-rocketed, allowing their emerging country CBs to accumulate substantial amounts of surplus funds.

The question that begs to be answered is: why is this happening today?

  • Deng Xiao Ping decided to open China to the world markets in 1978; and the Chinese low wages have allowed them to grow their economy at brisk annual rates ever since,
  • IT and communications technology have helped to breach the distances—the world is smaller,
  • and I would also emphasize that many countries around the world have learned painful lessons which have made CBs more independent,
  • and their financial systems more efficient and transparent—money flows more freely through international borders…

To be continued…