Outlook for Rates and the Curve
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Introduction

This week's commentary comes from Douglas Greenig of RBS Greenwich Capital in Greenwich, CT. I have been reading his material over the years and always find it solid and thought-provoking.

In this piece, we get one more look at Greenspan's "Conundrum." Douglas looks at some of Greenspan's arguments for the strange behavior of the bond market. He then offers up his own theory of why long rates have stayed low and why they are likely to remain there. Many market watchers, like Bill Gross of PIMCO, are starting to look at why long rates have stayed low and predicting they could go much lower. Douglas offers up some new ideas and that is why it was picked for this week's Outside the Box.

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Outlook for Rates and the Curve

by Douglas Greenig (6/10/05)

Alan Greenspan has swerved in the direction of the skid. After Federal Reserve officials had spent months trying, unsuccessfully, to jawbone the bond market lower, Greenspan has thrown in the towel by acknowledging that there must be powerful forces keeping long-term bond yields low.

In a speech to the International Monetary Conference in Beijing on June 6th, Greenspan noted: "The unusual behavior of long-term rates first became apparent almost a year ago. In May and June of last year, market participants ... built large short positions ... in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged .. that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short-lived."

Chart 1

Greenspan then explores alternative hypotheses for the unusual market behavior:
  • The market is anticipating economic weakness
  • Pension funds are immunizing liabilities by purchasing more long-term bonds, possibly due to demographic trends
  • Central banks have been purchasing treasuries (as part of programs to stem dollar depreciation)
  • Globalization has led to cross-border flows of saving into U.S. and other bond markets
  • Globalization has reduced inflation risk-premia
In sorting through these alternative explanations, Greenspan makes cogent points that bear repeating:
  • The "conundrum" is not merely a story about U.S. long rates, but is a global phenomenon: long-term interest rates are low globally and other G7 rates (ex Japan) have declined more than in the U.S.; risk premia have declined for many asset classes
  • "World demographic trends are hardly news, and recent adjustments to (pension) funding shortfalls do not seem large enough to be more than a small part of a complete explanation."
  • Foreign central bank purchases have lowered U.S. Treasury yields - but what about bunds, JGB's, EMD, etc. ?
The good doctor then lapses into perplexity - but acknowledges that powerful forces must be at work.

It's not that confusing if you look at the world through the right glasses. As I have noted in previous commentaries, the key ingredients in the special sauce are: the positive supply shock from globalization, technology-led productivity gains, rapid expansion in money and liquidity for a decade, and the knock-on effects of increased wealth and income inequality worldwide.

The supply-side effects from globalization and technology have not only been disinflationary but also have boosted global growth. The disinflationary impact is felt in many ways: e.g. cheap goods from China, weaker labor markets in developed countries, which restrains wage growth and (all else equal) spending, and so forth.

Countering these disinflationary forces have been reflationary forces: most notably, a long period of monetary expansion (see graph below) and expansionary fiscal policy (see the next graph below). (Notably, there has been no expansion, on either front, since 2003).

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The effects can be explored using aggregate demand and supply curves. It is well understood why the demand curve for a single commodity slopes downward, but we are speaking now of an aggregate curve relating national output and the overall price level. This curve does slope downward from Pigou's wealth effect (lower prices increase real wealth - hence, greater spending), Keynes' interest rate effect (lower prices lead to lower currency demand, lower interest rates - hence, higher investment spending), and Mundell- Fleming exchange-rate effects (lower prices lead to lower interest rates and a cheaper currency - hence, greater exports). Expansionary policies, like gunning the money supply or a spendthrift fiscal stance, shifts the aggregate demand curve out. (See below).

Chart 2


Chart 3

The aggregate supply curve is clearly vertical in the long-run. This means that national output is based on real factors like technology and greed, not the activity of a central bank's printing press. But in the short-run, money illusion (the temporary confusion of real and nominal quantities by businesses and consumers) and various rigidities ("menu costs," sticky wages and the like) can lead to an upward sloping short-term aggregate supply curve. In other words, reflationary policies can temporarily induce greater output by businesses. Supply shocks - like globalization and technology - can shift both short and long-term aggregate supply curves to the right.

The effects of a positive supply shock combined with reflationary policies are:
  (1) unambiguous for output: more
  (2) ambiguous for the price level (depending on curve shape and the shifts)

Chart 4
Now, we introduce an important complication. The effectiveness of expansionary policies in shifting out the aggregate demand curve is heavily influenced by how newly created money is distributed in the economy. If you put money in the hands of poor people, they tend to spend it on current consumption. If you put money in the hands of rich people, they tend to save it: i.e. buy deferred consumption goods (assets).

An overwhelming body of evidence suggests that wealth and income inequality exploded in the U.S. over the last decade. Although global data are problematic, most analyses point to a general global increase in inequality: partly because rich countries have gotten richer (cross-country inequality) and partly from increases in inequality within many countries. See, for example:
http://www.globalpolicy.org/socecon/inequal/2004/0615millionaires.htm
http://www.globalpolicy.org/socecon/inequal/2003/09inequality.pdf
http://www.levy.org/default.asp?view=publications_view&pubID=fca3a440ee

The latter paper contains the following table:
Chart 5

The bottom 40% (by income) had a decline in net worth from 1983 to 2001, whereas the top 20% had a 90% gain. Using wealth, not income, categories, the top 20% in wealth went from 81.3% of total net worth to 84.4% over this period. The bottom 40% had a 0.9% share in 1983 and a 0.3% share in 2001. The 40th-60th percentile band went from a 5.2% share to a 3.9% share.

So my claim is that the distributional story tells us that the expansionary policies have had a relatively smaller effect on current consumption - and have led to greater asset demand: less of an economic boom, more of an asset bubble. Hence, the aggregate demand effects have not dominated the supply effects; inflation (in current goods and services) has remained relatively tame.

"Excess" global saving (stimulated by an unevenly distributed surge in money and liquidity) neatly explains Greenspan's several conundrums. There is no reason for perplexed handwringing.

What happens now? Well, the demand-side shocks are dissipating. The incremental impact of fiscal policy is neutral now. Money and liquidity have ceased to grow. Yet the supply-side dynamics continue. This points to a moderate growth, low inflation environment, with a tendency toward disinflation. No wonder rates are low, and the curve is flat.

Is there a reason for the curve to invert, on a sustained basis? No. Not unless the Fed raises interest rates enough to engender a marked economic slowdown (GDP < 2.5%), in which case, the market will price future rate cuts.

The key here is housing. Over the last couple of years, employment gains in housing-related industries have contributed almost 1mm new jobs to the U.S. economy. It comes to about 40,000 a month, depending on when you start the analysis. Home price gains have lead to equity withdrawal: monetizing home price gains to buy iPods, Hulk Hands, boats and bling.

Chart 6

My take is that Fed would like to slow the housing market, not beat it down like a red-headed stepchild. Everyone understands implications of a broken housing market for spending and jobs. As ARM resets happen over the next few years, a crisis would occur if home prices were down, say, 20%.

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Greenspan understands this. Greenspan is listening to the markets. Two more singles and the ballgame is over. Then we will probably find ourselves in a sleepy, low-rate, low-vol, flat-curve environment. As this unfolds, you will probably wish you had bought more mortgages and sold more vol back when ...

That's my best guess, in any case. Good luck trading!

Conclusion

I hope you enjoyed this article by Douglas Greenig.

Your watching the yield curve analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

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Posted 06-27-2005 2:47 AM by John Mauldin