Conundrum, undone

Now that markets have had a few trading days to digest the Fed's surprisingly aggressive move on rates, (and dropped into bit of a lull actually), and readers have maybe wondered about “turning points” and “watershed moments” for one thing or another, m* thought it would be good to share the one observation that in m*’s view really deserves attention.

It is that the bond market has finally woken up to all the reasons why it is overpriced.

Experience during the "benign inflationary environment," of the Greenspan era, using the usual, mmm…, interesting price indices of course, was that lower rates on the front end actually supported bond purchases on the back end. So while rate cuts might lead to a steeper yield curve, they did not lead to higher long term rates.

At the same time, and more vexing to just about everyone, higher rates on the front end did not translate into higher bond yields on the long end either, leading to flattish yield curves in most major economies. Nor did dramatic fluctuations in fiscal position seem to have an influence as they once did.

It was as though the long end had become entirely divorced from actions at the short end, fiscal positions, trade deficits, and very strong economic growth globally, thus defying a whole set of accepted economic principles. This “conundrum” has become part of the global financial landscape as a number of happy circumstances in price measures and capital flows have conspired over the last decade to hold inflationary expectations (or just the expression of them in the bond market) in check.

Globalization meant that US price measures experienced downward pressure from Asian imports of manufactured goods and concurrent pressure on wages as more and more manufacturing jobs were transferred overseas. At the same time, a measurement quirk meant that a shift in preference for home ownership over renting left the housing component of inflation indices (owner imputed rent) practically unchanged while home prices, which are not a part of the government’s inflation calculation, inflated at double digit rates nationwide. (Say what you want about the real estate bubble, but an increased preference for ownership is a pretty rational response to an inflationary environment).

Globalization also meant that US debt markets benefited from the Circle whereby the Japanese and Chinese Central Banks (and more recently the Central Banks flush with petro-profits) recycle dollars received for exports back into US interest rate markets. Meanwhile long periods of easy policy by the Fed (and generous easing during financial downdrafts) also did their part to dampen risk on the long end and attract an epidemic of participation in the carry trade and an insatiable demand for yield instruments.

In short, the risk premium, (where long term lenders demand some additional yield for assuming inflation risk) was squeezed out of bond yields.

However, that appears to be no longer. And as long anticipated, (if you’ve known m* a while), it is weakness in the dollar that is finally changing the tone of the interest rate picture.

While the global imbalances crowd has long been focused on the possibility for an abrupt spike in rates due to a cessation of purchases of bonds by the Central Banks of the nation’s major Asian trading partners, the catalyst for such a change has never been clear. Trade frictions, political crisis, or in the longer term, a greater demand for capital at home have all been possible culprits.

However the potential for the weaker dollar, to this point reflecting shifting allocations by Central Bank reserve managers (and US retail investors!), to augment the inflation concerns already afoot globally is now reaching a serious level. Remember that prior to the summer credit crisis, both the Fed and the ECB postures were most concerned with inflation pressures, while currently the Bank of China is actively and utterly ineffectively engaged in a battle with domestic inflation of its own. Expect bonds and the dollar to trade together from here on out.