Thursday, December 18, 2008

Declining Treasury Yields & The Inflation-Deflation Debate

I have recently argued in several posts (for example this one) that the decline in Treasury yields (or in other words the interest rate on U.S. federal government debt securities) indicate increased monetary inflation. But at the same time, Mike Shedlock argues that falling Treasury yields are a sign of deflation. That would at least appear to be contradictory, so who is right?

At this point, you would naturally expect me to write that I am right, and indeed I do believe that I am right about this. Still, while I believe that Mish is wrong, it can't be denied that he could be right theoretically (which is to say under different circumstances, falling bond yields could reflect deflation).

To get to the bottom of this, it must be asked what possible reasons could there be for falling Treasury yields. The answer to that question is that there are broadly 4 possible reasons why Treasury yields may fall:

1) Lower inflation expectations. This reflects more deflationary (less inflationary) conditions and is thus a symptom of deflation. Though it should be cautioned that expectations are a lagging indicator, and when there is a dramatic increase or decrease in inflation, the turnaround in inflation will happen later.

2) An increase in savings/a reduction in the government budget deficit. This is essentially neutral from the inflation/deflation perspective, though in the long term, the higher production capacity this enables will push down prices.

3) An increase in risk aversion/liquidity preference. As government bonds ( at least in the U.S.) are perceived as risk free and are the most liquid asset around, increased risk aversion and/or liquidity preference will lower government bond yields. This is also basically neutral from an inflation/deflation perspective, though it will mean tighter credit conditions for the private sector, which will have a deflationary effect. On the other hand, the lower cost of borrowing combined with weaker private sector activity could encourage government to expand the budget deficit which would negate much of the aforementioned deflationary effect.

4) An increase in the money supply that is used to bid up bond prices. This is the case where inflation pushed down yields.

So, theoretically, a decline in government bond yields could reflect inflation, be irrelevant from an inflation/deflation perspective, or reflect deflation. This implies that falling Treasury yields alone can't be used as conclusive evidence of anything. In order to tell what it implies you have to look at other data as well. This brings us to the issue of what it is a result from.

Is it a result of falling inflation expectations? To some extent, yes, as is suggested in the dramatic decrease in the spread between nominal treasuries and inflation-protected ones (TIPS). However, much of the decline in that spread reflects the much higher liquidity of nominal treasuries and the increasing liquidity premium. And there are also other strange aspects of the TIPS market that makes it less reliable as an inflation indicator. Even so, it seems likely that inflation expectations have declined.

Is it the result of rising savings/a falling budget deficit? Hell no! While private financial savings have increased, the dramatic increase in the budget deficit means that this factor has in ceteris paribus terms acted to raise Treasury yields-and raise it quite significantly. Hadn't it been for the counteracting effect of the other factors, this would have translated into much higher yields.

Is it a result of higher risk aversion/liquidity preference? That is clearly a factor given the sharp increase in the yield spread between Treasuries and various others more risky and less liquid bonds. Though it should be noted that this increase in the yield spread has come in the form of falling Treasury yields, and not higher yields of for example corporate bonds.

Is it the result of a higher money supply? Yes, it definitely is. This evening's weekly money supply release again confirmed the aforementioned upward trend, with M1 rising another 3% in just 1 week, while M2 & MZM rose slightly below 1% each for the week. The cumulative 9 week increase is 8.3% (annual rate of 58.1%) for M1, 3.3% for M2 (annual rate of 20.3%) and 4.3% for MZM (annual rate of 27.5% . The monetary base is up 68.5% in 10 weeks (monetary base numbers are only published for 2 week periods), or 1,408% at an annual rate. This means that the inflationary monetary trends I discussed last week continue and are accelerating.

Thus, while the decline in bond yields may to some extent reflect a reduction in inflationary expectations as a result of the monetary contraction earlier this year, the main reason is the massive flood of liquidity unleashed by the Fed, in interaction with the increased risk aversion/liquidity premium.


Blogger Wesley R. Gray said...

So, here is the real question: are you actually betting on inflation going forward, or is this purely an economic discussion? That is a good gauge of one's confidence in a position.

I agree that printing money to buy bonds is inflationary; however, I find Mish's argument compelling (at least for the next few years). If banks keep that printed money in their coffers to fend off against future losses and if everyone delevers their balance sheet, the combination of money+credit may actually go down.

It seems to me that one potential trade here would be to short 30 year bonds. Presumably, as we crank up the printing press in the near future to insane levels, the extra dollars will eventually become inflation when the economy turns around in 2 to 3 years (if we're lucky). 30 year bonds at 3% probably aren't discounting 10-15% rates 5 to 6 years from now.

What do you think?
Great blog by the way--always has me thinking.

4:27 AM  
Blogger stefankarlsson said...

Well, it was actually meant as both a theoretical discussion and as a discussion of the current situation. And yes, I do think inflation will return very soon.

Banks are indeed reducing their leverage, which is why money supply increases a lot less than the monetary base. But that simply reflects how extremely high base money growth is. As I pointed out, money supply growth is very high, as the magnitude of the Fed's printing is overwhelming the effect of deleveraging.

Higher [non-transaction] money demand will limit the effect from higher money supply, and while it is possible that it could prevent price inflation, I think it is unlikely given how fast money supply is growing.

8:27 AM  
Blogger said...


Though I share your view that inflation will be on the table in the foreseeable future, Mish's view that currently we are experiencing deflation appears to be irrefutable to me. This deflation is fueled by production overcapacity, mainly in China, but also in the oil industry and the subsequent reactions of the producer nations. Yuan devaluation and too slow production restriction by oil-producers.

Do you know of any examples of government bond rallies in times of low (and declining) interest rates in countries experiencing high inflation?

12:18 PM  
Blogger stefankarlsson said...

Marc, one good example would be during World War II where Treasury yields remained extrenely low, despite massive inflation. Or how after the fall of the fixed exchange rate of the Swedish krona, interest rates fell sharply even as inflation rose.

As for yuan devaluation, I've seen no sign of that as the yuan remains near its high of slightly above 6.80 to the USD.

5:17 PM  
Anonymous newson said...

where are the figures for mzm? i could see only m1 & 2 on the h6 schedule, courtesy of your link.

1:54 AM  
Blogger stefankarlsson said...

Newson, the MZM number isn't formally displayed there, but it can be calculated by subtracting from M2 small time deposits and adding institutional money funds, which is what I did.

8:20 AM  
Anonymous Robert Szefler said...

Stefan, thank you for your comments on the inflation/deflation debate. Your explanation of yields is plausible, I think just as plausible as Shedlock's is. But please, answer a simple question, a question that weighs essentially on the issue: if the liquidity injections had/are about to have a significantly inflationary effect, where did the money go? I mean, come on, doesn't inflation mean a fall of money's purchasing power? How can you possibly reconcile falling purchasing power with ultra-violent price cuts in most imaginable dollar denominated markets? 4x fall in crude price, 2x fall in steel price, 15x fall in freight costs, almost 2x fall on capital markets. Aren't these facts a "little" problematic to explain in the "great inflation" theory?

9:44 AM  
Anonymous newson said...

thanks, but why don't you use the st louise fed's weekly mzm figures?

1:58 PM  
Blogger Dan said...

It seems to me that there isn't so much disagreement between Stefan and Mish. Mish is saying that the current condition is deflation and Stefan is saying that the actions taken by the Fed are inflationary (i.e. trying to reverse the current condition towards inflation). The fact that these actions haven't taken effect yet doesn't mean that they aren't inflationary in their bias. Mish seems to acknowledge the future problem, but side-steps the question of when it will take effect, as everyone seems to be doing.

The question that is occupying my mind every day is this: "How is the Fed going to smoothly undo this inflationary process as the economy recovers, so that interest rates don't soar?" I don't see how they can.

Even scarier to me, maybe they don't really want to avoid the inflation!

I'm guessing that the government will never explicitly repudiate it's debts. So, they have to repudiate in slow-motion by paying everyone back with worthless future dollars. What better setup for that sort of plan than our current conditions? I.E. To have everyone's inflation expectations so low, and for such a long time into the future that they almost beg the government to take their money in the present.

Or am I too paranoid?

10:15 PM  
Blogger stefankarlsson said...

Newson, because accessing raw data is simpler in the H6, despite having to type in 3 new numbers in the excelfile I have for that purpose.

5:27 PM  
Anonymous Anonymous said...

A quote from the newest post on Mike Shedlock's blog:

"Those who focused on Peak Credit and its counterpart Peak Earnings saw this [Deflation] coming. Those blindly looking at prices or money supply alone are still trying to figure out how and why treasury yields are where they are, the stock market has collapsed, commodities have plunged, and banks are scared to death to lend."

Mish has predicted every step of the unfolding economic course of events with amazing accuracy. He does agree that inflation will become a problem in the future.

11:13 AM  
Blogger Per Paterson said...

Inflation defined as incresing money supply and deflation as decreasing money supply. FED is increasing money supply (inflation) to buy Treausury Bonds, but that does not mean the price on food or gas will go up now.

I would never short the bondmarket with FED with unlimited money on the other side. As soon as FED announced it's quantative easing policy prices on bonds went up and yields down. The FED will keep it there until prices (PPI and CPI) are going up again and that may take a long time, like in Japan.

There is deflationary forces such as credit losses in the banking system that FED is fighting with unlimited new money. The banks are now lending for 0-0.25% from FED and lend it back to the FED for 1.25% and they are not lending to business and consumers, yet.

To get the economy growing again, consumers must start to demand products and services so business can sell and produce and employ workers. To do that they first must pay off old debt so they can take on new debt and start consuming again. That will take a long time if not the FED give every American a one million dollar check, but the consumer might even then just pay off all old debt on house, car and credit card and just save the rest.

Right now we know that the world central bankers will decrease interest rates to 0% and start buying Bonds.

If the FED does not start to buy unlimited amount of shares the stockmarket will continuing to trend down. Japan shares is down about 80% from All Time High in dec 1989 at 39000, 18 years now.

3:02 AM  

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