Known Unknowns: The bond issue
Welcome to Known Unknowns. A newsletter that this week is a very special issue: It’s all about bonds.
Pension Geeks spend lots of time thinking about bonds. They are how we value liabilities and manage risk. We obsess about them when few others take much interest. Lately, however, the bond market has become interesting: Now everyone is an armchair bond analyst. What better way to end the summer than with a newsletter on what’s happening?
What’s going on with the yield curve?
First, what to make of the inverted yield curve. Not much. I’ve yet to hear a compelling reason why it means there’s a recession coming. I'll take why it causes recession or whatever it is that causes an inversion also causes a recession. I am wary of a correlation without an economic mechanism, especially one that only has several observations.
But if you want to entertain yourself, ask people why a yield curve means a recession, and you’ll hear all sort of crazy things. It usually comes down to that bond buyers know a recession is coming or just think the Fed will cut rates because a recession is coming. Never mind that the Expectations Hypothesis has iffy empirical support; this all assumes that bond buyers are these magical soothsayers who can predict a recession. What makes them so special? Historically, after the curve-inverted stocks continued to rise. Why do we assume bond buyers can see the future and stock buyers can’t? Do they have access to special information or are they just smarter than everyone else?
No one can answer these questions. Maybe a recession is coming later this year or next year or the one after, but I am not convinced bonds tells us anything either way.
What’s going on with low or negative rates?
More than $13 trillion worth of bonds offer a negative yield. The US yield curve could be next. The financial economist in me says this is all fine: If this is where the market prices bonds, it’s where the market prices bonds. Though, we can quibble about who is buying bonds and if it’s creating a distortion.
Governments (including the US buying its own bonds) are buying lots of them and requiring institutions to buy even more—and maybe that’s a distortion. But I am not sure it is, at least I don’t blame the Fed. In any case, demand is just big and this pushes bond prices up.
The macroeconomist in me wonders what it all means. I can think of two reasons why bond yields are normally positive.
Investors need to be compensated for rate and inflation risk (let’s assume no liquidity risk since these are government bonds and high-grade corporates with a deep market—though maybe liquidity should be on the list, too).
People value consumption today more than consumption in the future and need to be compensated for giving it up.
Joe Weisenthal argues the risk-free rate should be negative because it serves a function; it’s a store of value. I agree that we may be seeing lower rates than before because bonds, in some ways, have never been less risky (which is a weird thing to say about an asset whose prices are reaching record highs). Inflation is low and stable, and people are betting bond prices won’t go down, which means bonds are truly “risk-free” in a way they weren’t before—so, yeah—maybe they should be negative.
The second point, however, which Joe and most commentators are not addressing, is far more interesting. The time value of money concept, i.e., the idea that money you have to spend today is worth more than money in the future is important. It is the foundation of asset pricing and lifecycle economics. Negative rates suggest that people value consumption in the future more than today.
Is it time to cue up The Atlantic think pieces on how misguided economists are and how we infected the world with our original sin of assuming people are rational, evidenced by yet another model failing? Not so fast. I urge editors to first ponder the higher-order properties of inter-temporal utility functions. Because it is there that we can really get a sense of what is going on in the economy (and they vindicate mainstream economic models—as higher-order properties often do). I can think of three reasons why people (or institutions) would pay to defer consumption.
They want to consume in the future but know they won’t have income then (say if they plan on retiring).
They have a strong precautionary motive: they plan on income in the future but are worried they won’t have it.
They are fully satiated and the marginal value of consumption tomorrow is higher than consumption today
Each of these may be going on, to some extent, for retail and institutional investors. Individuals and pension funds need to save for retirement (or someone’s retirement). Bonds are the least risky way to do that. So, if they want to have secure income, they need to invest in bonds. Pension funds sometimes even face regulations that force them to invest in bonds, no matter what the price.
The precautionary motive is where risk comes in. Investors, of all kinds, may be nervous about trade wars in the fact Europe can’t get its act together. All of which could mean income will be lower or nonexistent in the future. Standard economic models assume people hate cutting back on their consumption—they’ll save when they fear something threatens their future income.
I am less convinced by point three. People always seem to want more, e.g., a bigger house, a nicer vacation. But perhaps this describes some institutions. Perhaps they don’t want to hire more or sense compelling investment opportunities (I know I am blurring the lines here between consumption and investment, but bear with me) today and think better ones will be available in the future.
I should also add another finance theory: that investors think bond yields will go even lower because there’s some QE in the offing and foreigners, pension funds, and governments will keep buying bonds no matter what. Even a negative rate will pay off if rates fall further. Or maybe not. Social Security is one of the biggest buyers of US debt and will stop buying it soon. Foreign buyers are also losing their taste for US governments. Hmmm...maybe bond buyers aren't as smart as people think.
So there you go. I love fixed income: it tells us so much about the economy. But I don’t think it can predict the future. If it’s any consolation to resentful Millennials, low rates really stick it to Boomers.
See you after Labor Day, Pension Geeks!