US Government Bond Market & Interest Rate Watch – No Signs of Worry Over Deficits, Inflation, or Default

Just a quickie to bring your attention to this, yesterday’s close on the U.S. Government bond market as reported by Google Finance. Note the 10 year bond – less than 2%.

Bond Maturity Yield (effective interest rate) change in points(percent)
3 Month 0.01% 0.00 (0.00%)
6 Month 0.04% +0.01 (33.33%)
2 Year 0.19% +0.01 (5.56%)
5 Year 0.86% 0.00 (0.00%)
10 Year 1.99% -0.07 (-3.40%)
30 Year 3.30% -0.11 (-3.23%)

Why does this matter?

There’s two reasons.  First, the politicians and economists who have been opposed to stimulus efforts, either deficit spending increases or monetary stimulus, have been screaming for well over three years now that  these policies were “reckless” and going to lead to inflation.  Some of the more shrill have been seeing “hyperinflation just around the corner”.  They’ve been saying this for a long time but the inflation and hyperinflation simply aren’t happening.  Why?  Well they’ve argued this because they subscribe to economic theories such as quantity theory of money, crowding out, efficient markets, and a whole host of other neo-classical/neo-liberal theories.  These are the same people that claim Keynesian or post-Keynesian or Modern Monetary Theory is totally wrong.  But the data disagree.  These same critics were the ones pushing Washington to cut the budget and not raise the debt-ceiling limit.  They put concerns about the deficit ahead of concerns about jobs or growth rates despite having over 9% unemployment and over 16% slack in the system. They’re wrong. The data and investors in markets are showing them wrong.  Bond buyers aren’t worried about the U.S. becoming another Greece because they know it’s not possible.  Instead the big money is worried about the lack of economic growth and the potential for banking failures in Europe, and that leads them to want to park their money in the safest thing around: U.S. bonds.

The second reason is because these rates are so low, it’s foolish for the government to not borrow more money and invest it in the country’s future. Readers of this blog and my students should know that the U.S. government is not like a household and doesn’t  face the same budget constraints.  But even if you do believe that, why wouldn’t you borrow money at less than 2% and invest it in projects like infrastructure, innovation, and education that bring a rate of return well above that?  There’s no evidence that the private sector is doing any of this investing and the nation has plenty of idle capacity and idle workers that the private sector has shown it won’t hire.  Why shouldn’t a rational government borrow and invest in growing future GDP?  There’s no reason not to as long as you are sincerely committed to economic growth.

If we consider the real rate of interest (the nominal or face rate of interest minus the expected inflation rate) we get pretty much 0%.  The money is being offered to the government essentially for free, yet opponents of stimulus don’t want to borrow it. Proof of this is that TIPS bonds, which are a variety of U.S. government bond where the interest payments and principle is indexed for inflation, are trading with a negative interest rate these days.  The ironic part is that the very people opposed to government borrowing in this environment are often the same people who claim government should act more like a business.  Any rational business that had profitable investment opportunities and also had access to borrow at essentially 0% would rush to say “where do I sign to borrow?”

The Market Shrugs Off Rating Downgrade, Market Is Worried About Real Economy.

It’s now Monday morning, Aug 8.  It’s been roughly 60 hours since S&P downgraded the rating on U.S. government bonds.  In that 60 hours the media, particularly TV talking head channels, have been breathlessly awaiting what they felt was a certain market panic on Monday. Clearly interest rates would go up they said.

They were wrong.  The early results are in.   U.S. government bond prices have  gone up this morning!  That means government bond yields (interest rates) have actually gone down!  The 10 year bond actually dropped from 2.6% yield on Friday’s close to 2.48% at 9:30 am ET on Monday.

It’s really no surprise if you pay attention to real economic events and not listen to the TV media types who think talking in serious tones is a substitute for actually understanding economics.  First, serious investors, the ones who vote with their money in the market already know everything that S&P knows.  In fact, they know S&P has a really bad track record. So the rating doesn’t mean much to them.

What does matter is what choices or alternatives they have for investing their money.  Right now, the signs from the real economy in both the U.S. and Europe are grim.  Europe is struggling to achieve any growth outside Germany with several major economies actually declining due to their governments’ embrace of budgetary austerity.  The U.K. is on the ragged edge of another recession, again due to government cutbacks. The U.S. is barely registering postive growth with only 0.8% growth rate in the first half of 2011.  It’s clear, too, from the debt ceiling debate that the U.S. won’t be seeing much stimulus anytime soon and likely will join the Europeans in austerity budget cutting. Cutting that will only slow the economy further and possibly drive another recession.  So what theses investors know is that economic growth isn’t likely and that’s bad for stocks.  Stock markets aren’t the place to be now.

Further, Europe is continuing it’s slow-motion debt default crisis issues.  In the past week or so the crisis has spread beyond Greece, Ireland, and Portugal. Now it’s Italy and Spain too.  Even AAA-rated France is finding it’s bonds trading at significantly raised interest rates.  Now the debt crises in Europe are real problems because the nations inside the Euro zone don’t have control over their own currency, they don’t have a central bank, and they borrow in some other currency (Euro) rather than one of their own.  This is unlike the U.S.  The problem is the uncertainty the debt crises in Europe are creating.  The global financial and economic system is once again showing great signs of weakness, fragility, and uncertainty – just like 2007 and 2008.

When uncertainty abounds and about the only sure thing is that growth will be weak at best, it’s time to put your money in something safe and wait it out.  The safest thing in the world (in any volume) is still U.S. government bonds.  So what we have is investors moving into U.S. government bonds because they don’t want to be in anything else.  Everything else is too risky.  So we get increased demand for U.S. bonds and that lowers interest rates on those bonds. This is what financial analysts and economists call a “flight to safety”.

Innovation in Monetary Policy in Sweden Works: Negative Interest Rates

The Sveriges  Riksbank (a.k.a.  Riksbanken), the Swedish central bank, tried an innovation in monetary policy two years ago in July 2009 when it set the official deposit rate at a negative interest rate of -.25%.  The objective was to stimulate and motivate banks to lend their “excess” reserves to businesses and households and to therefore stimulate the economy.  The Riksbanken was the first central bank to try a negative interest rate and as far as I know, it’s the only one that has tried it.

The results of the experiment look pretty good.  The Financial Times has reported that Sweden’s economy has come roaring back from the depths of the global recession.  It recorded a 7.3% growth in real GDP for 4th quarter 2010 (year-over-year). Fast enough growth that the bank has long since found it necessary to raise interest rates back into positive territory.

So what happened here? And how does a “negative interest rate” work?  Monetary policy is primarily handled by changes in interest rates. In particular, central banks change interest rates on their dealings with commercial banks in their country.  Remember a central bank is a “banker’s bank” – it’s where your average ordinary bank, be it JP Morgan Chase or Podunk Community Bank, has both deposit accounts and loan accounts.  The average commercial bank keeps a certain amount of money on deposit at the central bank. This is what are called “bank reserves” (technically currency in the vault also counts as “reserves” but it’s minor statistically).  Reserves are used to handle transactions with other banks (customer checks to be cleared) and, sometimes, as a cushion for safety. In normal times when the economy is growing and there are plenty of credit-worthy people to lend money to, a bank wants to hold only minimal reserves.  In fact they want to hold only enough to handle any withdrawals such as clearing checks to other banks.  Historically banks would be required to keep a certain % of their deposits as “reserves”.  However, in many nations that’s no longer true (Canada, Japan, Australia).  It’s partly true in the U.S. where demand deposits (checking accounts) have a minimum reserve requirement, but not true for savings deposits.  The reason banks don’t normally want to hold reserves is because they can make more profit by lending the money out.  But lending is only attractive (read highly profitable) in normal times.  In times of crisis, recession, and panic credit-worthy customers are harder to find.  Banks raise their lending standards and become more focused on security/safety instead of making more loans.  So the amount of reserves tends to rise as the banks are reluctant to lend the money.

So banks have deposit accounts called “reserves” at the central bank.  But banks also can borrow from the central bank when they want or need more reserves.  The central bank can arbitrarily set the interest rate for both of these, the deposit (reserve) accounts and the loan accounts (discount loans).  Historically, the Federal Reserve Bank in the U.S. has only set an interest rate on the loans to banks – this is the “discount rate” and it’s set by the Fed Board.  (it’s closely related to the “fed funds rate”, but that’s a whole other story).  Again, historically the Federal Reserve Bank never paid interest on the reserve accounts.  They required banks to keep them, but wouldn’t pay interest on the deposits.  That changed in October 2008 when The Fed finally did what others have long done and took the new step of paying interest to banks on the reserves they keep on deposit at The Fed.  I believe the current rate is 0.25%.  Not much, but when figured on hundreds of billions of dollars that are just sitting there securely at The Fed, it’s a nice source of profits to banks.

Therein lies a problem.  In the crisis banks accumulated very large reserves. Reserves are now much greater than what the need for transactions suggests.  In effect, banks are simply sitting on the money.  They have the funds to make loans but choose not to. Instead, they choose to let the reserves sit idle rather than loan them out.  It’s a nice deal for the banks.  Nice safe profits with no risk. But it’s a problem for the rest of us.  We need a growing economy. And a growing economy needs consumers and businesses to spend more.  Consumers need to buy more and businesses in particular need to spend more on investment and expansion if we are to create jobs and grow the economy.  Problem is, businesses and consumers aren’t getting the loans they need.  Why?  In part because banks want to sit on the reserves.

The solution?  Obviously we need to lower the interest rate paid on the reserves so that banks would choose to make loans (at least constructive loans, not just loans to buy derivatives) in larger volume again.  Well with an interest rate as low as 0.25%, one-quarter of one percent, it’s hard to go much lower.  Or at least that’s what economists and central bankers have long thought.  We thought there was a “zero lower bound” which fancy talk for “interest rates can’t be negative”.

Now we return to Sweden.  The Swedes at the Riksbanken thought “outside the box”, or at least outside the “lower bound”.   They lowered the interest paid on bank reserves deposited at the Riksbanken to a negative number: -0.25%.  In effect, Swedish banks now had to pay the Riksbanken for the privilege of keeping the reserves at the central bank.  As their chair explained, it was, in effect, like having a penalty tax on holding extra reserves.  The idea was to motivate banks to reduce the level of reserves to what they really needed for transactions and take the rest and lend it.  By lending it, it would lower interest rates charged to business and consumers (‘banks compete, you win!’). Businesses and consumers take their new loans and spend the proceeds.  Spending makes sales at businesses. GDP grows. People get hired.  The economy recovers.

It worked. Dramatically.

And it worked.  Sweden’s growing now at over 7%.  They’re now concerned about how to keep the economy from overheating.  We in the U.S. should be so lucky.  Instead we’re still stuck with anemic growth of around 3% despite unemployment of near 9% or more.  Both the government and Federal Reserve continue to be concerned with the health of the banks – whether they are profitable enough and have enough reserves.  We’re worried about helping banks, but nobody is willing to make the banks help the economy through the right incentives.

The challenge getting an economy to recover and grow again after

Crowding Out Not Gonna Happen Soon

With unemployment hovering near 10% for nearly two years now, it should be obvious that the economy is no where near capacity.  Yet, many on Wall Street and in the talking-head TV shows continue to maintain that government borrowing is “crowding out” private investment (or going to soon).  Um, I don’t think so.  Crowding out would be seen in rising interest rates.  But a look at the data shows we’re still hard against the “zero bound”.  In other words, interest rates are still about as low as they can go.

US Government Short run interest rates near zero for 2008-2010

There’s No Crowding Out Here.

People who worry the most about the recent increases in US government borrowing are generally worried about one of two things: crowding out or inflation.  They fear that either if The Fed doesn’t “print new money” for the govt to borrow, then the government’s demands for borrowing money will drive up interest rates.  This driving up of interest rates would then, in turn, discourage businesses from borrowing/expanding/growing.  I’ll deal with the inflation fear in a different post.  But right now, it appears there’s little prospect of crowding out.  It’s true businesses (and households) aren’t borrowing, but it’s not because of high interest rates.

In the past, when the government became a heavy borrower, there was talk about crowding out private borrowers. But this time, interest rates have remained low and no one seems to be worried about that.

The reason is simple: Rather than crowding out the private sector, Uncle Sam is now standing in for it. Much of the government borrowing went to investments in financial institutions needed to keep them alive. Other hundreds of billions went to a variety of programs aimed at stimulating the private economy, including programs that effectively had the government pick up part of the cost for some home buyers and some auto buyers.

via Off the Charts – A Rich Uncle Picks Up the Borrowing Slack – NYTimes.com.