Friday, November 30, 2007

Paradoxical Responses to Fedspeak

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.

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Anonymous jack said...

The 'flight to quality' is likely equity to fixed income not simply equity to treasury. Even if it were, the proceeds of all those sales have to go somewhere and it will mostly be cash or other maturities or credits which might still mean a steep change in demand and therefore price.

There are explicit asset allocation models out there, in pension funds for example, which mandate some institution, and therefore market, responses.

Fri Nov 30, 11:39:00 AM EST  
Anonymous Karl Smith said...

My guess is that bond holders believe that the channel of monetary policy runs through instruments other than than treasuries.

For example, I would check commercial paper rates against treasuries. Thats one potential non-treasury channel. The prime rate moves lock step with funds rate and so that is another potential channel.

The primary channel probably is willingness to lend to marginal credit borrowers.

Suppose, that the Fed is more hawkish. This implies that marginal credit borrowers will find a harder time getting loans. This may imply lower utilization rates and hence lower profits.

Decreasing profit horizons not necessarily rising discount rates drag down stocks. Expecting the return on stocks to be lower, investors move into treasuries.

In a round about way one could say that the interest rate for the most credit worthy borrowers is determined by the marginal productivity of capital while the interest rate for less credit worthy borrowers is determined by the money supply.

A shrinking money supply can thus imply lower interest rates for the most credit worthy borrowers.

I know you mentioned eurodollars but the risk there is still small compared to a average or poor credit consumer or small business.

Fri Nov 30, 05:54:00 PM EST  
Anonymous Anonymous said...

I just think doves are more interesting than hawks.

Fri Nov 30, 09:54:00 PM EST  
Blogger knzn said...

Karl, I think to make your scenario consistent with my data, people have to be expecting the spread of fed funds over treasuries to widen when the Fed tightens (which seems reasonable by itself) but also expect the spread of LIBOR (eurodollars) over fed funds to narrow at the same time (which doesn't seem reasonable to me) even as the spread of commercial paper over treasuries widens.

Fri Nov 30, 10:40:00 PM EST  
Anonymous jack said...

You can't think of the TED spread as a simple credit thing at the moment. Even if the liquidity squeeze is credit related it has its own dynamic, for example implied overnight rates for December 31 in euros hit 14% this week. It could narrow even with rising corporate credit spreads even without sectoral considerations.

Where do you think the "stitch in time" theory might be wrong?

Sat Dec 01, 06:16:00 PM EST  
Blogger knzn said...

I just think the bond market is overestimating the chance of a recession, and perhaps overestimating the influence of current Fed policy on the outcome. It's hard to justify the current 2-year yield except under the expectation that a recession is a near certainty.

Tue Dec 04, 04:51:00 PM EST  
Blogger BaughSIU said...

knzn i agree with you. not just in the bond market, but within the entire economy. aren't we taught as economists that the economy goes through cycles, ups and downs, highs and lows? we've seen housing and credit crunches before. we have been through an oil crisis (though i wouldnt call this a crisis, we are just getting skewered by the oil companies). it seems that everyone is overreacting to everything that is going on. the fed is doing what it thinks is right, and the natural motion of the economy should fix itself.

Tue Dec 04, 06:16:00 PM EST  
Blogger Brian Faster said...

baugh@siu is completely correct in the skewering we are taking over on these gas prices. I think "bending over" might be a better term though. And with the question about the recession, I don't feel that is a negative thing. Recession for two consecutive negative quarters is not a big issue as people like to make it out to be. It only means that production levels are at a standstill, but not necessarily on a downfall. These situations are predicted for the future and they should always pan out due to the many factors leading up to them. It's a buyers market right now, meaning interest rates are currently low, so it is a good time to invest during this quote unquote recession.

Tue Dec 04, 07:16:00 PM EST  
Anonymous Anonymous said...

It appears that there is indeed a lot of concern over the recession, and I couldn't say whether this behaviour is common when recessions are forthcoming. Perhaps this execssive concern arises because there are so many other issues, like the climate change crisis coupled with steadily increasing global demand for energy, increasing water shortages or water quality issues around the world, and the ongoing Iraq war fiasco. When you add it all up, things are looking pretty bleak, and the recession is just another irritant. We could all be a lot more optimistic if the developed world's middle class and the world's upper classes could simply learn to live with less and politicians were competent enough to address real as opposed to manufactured threats.

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