Allison's Ode to the Second Moment


Welcome to the 49th issue of Allison’s Ode to the Second Moment, a newsletter about bonds, babies, and different kinds of sinners.

What’s Up with Interest Rates Going Up?

Markets, or people who make money talking about markets, are in a tizzy because the 10-year bond yield exceeded 3%—the highest rate since 2011! People have very short memories. Bond prices behaved like the stock market the past 10 years. Prices kept going up with hardly any volatility. Neither of these things are natural, especially for bonds. Stock prices can keep going up, but bond prices—or so we thought—revert to some long-term average.

The hot question is this: What do they revert to? Is the 3% the new long-term average or is it 6%, the rate you’d get if you use more history? Here is the big question in finance: What time frame do you use to measure expected returns? It is not a stable estimate. I guess it all comes down to your view. It could be argued that a post-Volcker era Fed can credibly keep inflation low, so bond yields will be low and you should use a short history. Or, you can argue that, when in doubt, use all the history available, in which case bond yields will keep rising to 4% or even 6%.

Yields exceeding 3% should not be surprising, but the fact yields went so low and stayed there is. While everyone gets nervous about yields crashing the stock market (seems like everything makes people nervous that the stock market will crash and that makes you wonder how fragile the market is), it is worth remembering there are both winners and losers with higher yields. Debt payments might go up, but insurance premiums will go down. The risk-free return on saving will increase and pensions will be a little less underfunded.

Perhaps we should worry about the 10-year yield not increasing enough. The Fed is increasing short rates and the curve is getting flatter. Atlanta Fed Governor, Raphael Bostic, said it’s the Fed’s job to keep the curve from inverting. This may sound like an innocuous statement, but it raises many important questions for Fed watchers: How will they do this? Will the Fed stop increasing rates or will it start selling all those long-term treasuries it bought during QEs? Does the Fed mandate now include an upward sloping yield curve?

True, a flat or inverted curve can be problematic; not because it means a recession is coming. A yield curve that changes shape makes it harder to hedge interest rate risk and that could have consequences for institutional investors.

Speaking of interest rate hedging. There is speculation that tax reform, specifically cutting the corporate tax rate, might mean corporations issue less long-term debt. A smaller supply of long-term bonds makes it more expensive to hedge interest rate risk and may flatten the yield curve—despite the Fed’s best efforts to keep it steep.

I Think We Can Now Call It a Trend

The birth rate fell for the third year in a row. It plummeted during the Great Recession, as it normally does, and never fully recovered.

It is tempting for both sides to politicize the falling birthrate.

But when you look closer at the numbers, it is mostly good news. There is a cyclical component to fertility, but the recession-related drop masked a longer-term trend: young Hispanic women are waiting to have babies. As communities get richer and better educated, they tend to delay having children. For the last few decades, United States appeared in better shape demographically than Europe because of the influx of very young Hispanic immigrants who had lots of babies. As successive generations assimilated, and Mexican women south of the boarder became more prosperous, young Hispanic women delayed having children. These falling birth rates reflect the Hispanic community’s economic success.

Over all, teen birth rates have fallen, down 55% since 2007. The only women having more babies are in their 40s.

It seems like something we should be celebrating, even if fewer babies means we can’t pay for entitlements.

I’d Like to Clear Something Up

I may be one of the few people left who believes in the natural unemployment rate. Yep, even though unemployment is 3.9% and inflation is still low. Maybe it's because I am a student of Ned Phelps and have a different definition than most people.

I was taught that unemployment can be caused by several different factors. Some are demand-driven and sensitive to monetary policy. Others are structural (skills, job location, and reservation wages) and not so responsive to changes in interest rates. The total unemployment rate reflects both of these factors. That means the Fed can influence some unemployment but not all of it. When the Fed says “natural unemployment,” it means the demand kind that it can't control. Sure, if the economy runs hot enough, it can pick up some structural unemployment but not much.

And here’s the thing most people get wrong about the natural rate (the structural rate is probably a better name): it changes over time and it is sensitive to policy—fiscal policy. I find it odd that there’s a popular, hardcore Keynesian argument that the Fed must keep rates low because there is no natural unemployment rate after all. I’d think they wouldn’t be so quick to let the rest of the government off the hook and leave unemployment all on the Fed. Fiscal and monetary policy are complements--not substitutes.

Ned has some ideas why the natural rate is lower than it used to be. It is also worth considering that inflation is lower because of demographics. I also wonder if inflation targeting has altered the Phillips curve. Perhaps the coefficient on the difference between expected and actual inflation is different because reducing inflation risk in markets altered how monetary policy works. Tyler Cowen reminds us that we barely understand this mechanism to start with.

Also, even if there’s low inflation, there are other costs to a low-rate policy. There are financial markets and they can do funny things when rates are kept too low for too long. Just look at the insurance industry.

Other News

  • The FT asks if we should measure tail risk, or existential dread. The data may show wages are finally increasing and unemployment is low, but people are worried about issues the data does not capture.

  • There’s a new NBER paper on pension systems around the world.

  • There’s a crackdown on emotional support animals you can fly with, but fear not, you can still bring your miniature horse onto a plane.

  • The Pope thinks bond insurance is immoral.

  • Maybe the problem with incels is there aren’t markets in everything after all.

Until next time, Pension Geeks!