savageinfidel

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble. Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy. The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed. In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage a...

Here’s what I wrote last week : Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory. Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson : There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline pr...

My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble. Nonetheless there are certain indicators that suggest we may be entering bubble territory. Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post , in order: 1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead 1 . Central banks are also less independent than before 2 . Finally, central banks have explicitly moved from tryin...

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length: In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise? The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation. But one doesn’t hav...

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn. Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals . In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth. So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order: 1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed 2. The end of the cold...

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory. So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race . All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current unde...

Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer. If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm. My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader ; scale invariance in bubbles ; feedback effects in bubbles ; the link between asset price bubbles and jobless recoveries ; the identification of bubbles ; and the stages in th...

In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction. Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece: Because the secon...

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1 . And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity. Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ t...

Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser . I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’. His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years. M...

Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’ 1 . Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser : As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. Others are more cautious, and would like to see a rebound in employm...