Friday, January 09, 2009

2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.

The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010. Until housing prices start to rise, we'll see persistently poor final consumer demand. This in turn keeps the velocity of money low and thus the money supply contracting.

I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.

If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.

Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels.

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially. But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates.


PNL4LYFE said...

How do f/x rates factor into the argument? I know other currencies like EUR and GBP have their own problems, but I don't see how the dollar can rally in the medium/long term against currencies with current account surpluses. This seems to be a popular view, but there must be a counter argument; anyone know what it is?

Accrued Interest said...

I think the dollar has to get weaker. I personally am long JPY, but also think that Trichet might be making a huge policy mistake which will result in an artificially inflated EUR.

I think of currencies in terms of interest rate differentials. With US rates falling rapidly, and JPY unable to realistically fall, I think JPY is the safest bet.

Once inflation picks up, which it will eventually, the dollar gets hurt hurt pretty badly. I think this is a risk the Fed is willing to take.

In Debt We Trust said...

Ag will be the leading indicator of inflation - not housing prices. So far, conditions are setting up for a bullish environment by early summer.

Yes, lower housing prices will help depress money flow but eventually something else has to give and that will be in food prices. As you know food and energy are the most inflation sensitive items for consumers (and naturally excluded or sidelined from most government statistics).

1) Farmers are already stressed by lower credit availability.

2) Early warning forecasts on US governmenet satellites are showing La Nina conditions developing in the Pacific.

cap vandal said...

The ultra short treasury etf's are all the rage:

Jan 5th Barron's cover features risk in treasury, Back Cover -- Full page ad -- ProShares Ultrashort Treasuries (PST and TBT).

This is so obvious that it can't work.

Maybe these are the srs and skf of 2009.

Alex Morrow said...

For the uninformed. What is a bullet agency?

Accrued Interest said...

An agency with no call feature. Callable agencies won't appreciate if rates fall, they'll just get called away.

formerly of greenmonday said...

i follow your comments/logic, however, what i think is not taken into consideration is that treasury yields (esp. in the long end) have been mis-priced for many years because of global imbalances in trade.

a re-adjustment in global balances can/will trump any negative effects of negative growth/inflation.

we never started this move from a place of "fair value".

In Debt We Trust said...

What is your take on China? I read your article again and found no mention of America's largest

Tradesense said...

"Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't."

The objective of government spending is to break the circular loop and make private lending happen. But the collateral damage is that even if private sector wants/needs to borrow, the banks are unwilling as they have safer avenues which are government backed. Given that such large amounts of borrowing to fund (TARP & Cousins) and Obama bailout will happen over next 3 years or so, government becomes an intermediary to the surplus holders (becoming a bank to essentially banks and other financial institutions) and channeling it only to sectors that it believes needs to supported. This may probably lead to lopsided growth. The packages need to involve the private sector across the board to ensure some level of homogeneity.

Further as the surplus gets absorbed there is a good chance that on the margin borrowing costs would increase. Also this time around other countries are also going to compete for their own packages. China it appears has its own plans of using its reserves.

And at the end what is the US government doing – creating money and borrowing it back to fund the rescue plans and packages. And some point in time
this “quantitative easing” has to reverse at which time cost of doing business for the private sector is going to shoot up.

For a lot more…check out .

Accrued Interest said...

Debt: Asian investors continue to gobble up Tsy. They were dumping GSE debt in Oct/Nov, but I'm hearing that may have reversed in Dec.

So when you say China, are you talking about a Tsy dumping scenario? I've never been a believer in that theory, and have talked about it serveral times.

A bigger risk is that Petrodollars dry up, simply because there are less of them. Domestic investors are not pouring into Tsy, its all foreign buyers on the long end. So I'd say fewer mid-east buyers is a risk. I think those are more short-mty buyers tho.

K T Cat said...

Great post! I would suggest that while the US may be able to sell its debt in this environment, other countries are going to have some serious problems. It's not just that Obama's going to borrow trillions, it's that everyone else is trying to do it at the same time. To me, it looks like America gorging itself on foreign investment money. I wouldn't want to be trying to sell Greek or Italian bonds right now.

To me this is all very short-sighted. There may be no alternatives in the private sector now, but when companies finally decide to start expanding again, those trillions will be locked up. Also, the effect on the government budget is going to be onerous for decades.

In Debt We Trust said...

Accrued Interest,

So, when oil finally bottoms what does that mean for treasuries?

Also, do you see a risk for political blowback from the mainly Muslim oil exporters given current events in the Middle East?

HoosierDaddy said...

Ag will be interesting. Input costs were soaring before the credit collapse.

Meats work on such a lag. We are going to be hit soon with pork production cutbacks put in place during the Commodity Bubble.

It seems like a lot of sectors are looking for a short period of deflation followed by a sharp inflation triggered by supply destruction.

Darth Toll said...

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing.

Isn't this a contradiction? You said that the government is not crowding out the private sector, yet the only areas that lending is happening is those that have government assistance. Isn't this crowding out?

Lockstep said...

Good post, AI

Accrued Interest said...

Darth: It isn't a contradiction if I believe that private sector lending wouldn't be happening regardless. Its only crowding out if normal lending would be happening but the government is attracting too much capital.

Put another way, I don't believe the government can be crowding out when interest rates are exceptionally low. Right?

Darth Toll said...

AI, you argue that the private lending market wouldn't have been lending regardless, but now we are seeing the law of unintended consequences where the government first began by bailing out some entities. Then, as the crises spread, they bailed out more and more entities. Now there are TARP's, money-market guarantees, and numerous other alphabet-soup programs as the net widens. The lender of last resort has become the lender of only resort - where folks now won't touch other private-label credit instruments if they don't have explicit government backing.

You see how the problem is self-reinforcing? The more things the government guarantees, the less folks are willing to accept anything less than government-backed issues, and the more the private credit market will seize-up as a result. The Fed is the main source of the problem as they are now seen to bless certain instruments and all others be damned. Pretty soon, all others will be damned or the net will cover the entire credit market. You said yourself that you see interest rising dramatically in a couple of years, and this sounds right.

High interest rates are the last (and final) symptom of crowding-out, and the long end will go much higher than you imagine if my theory is correct - 15%, 20%, who knows? We've still got a ways to go before the bond bust, and by then it will be too late. Now is the time to address this. IMHO, the Fed needs to reverse this insane collision-course immediately before they kill the entire credit market.

If TPTB didn't bail out anything, there would be blood in the streets - for a while. But then the accurately priced risk would start getting a bid again as folks tired of the minuscule treasury return, and once all of the entities with too much bad debt failed and we could see who was truly worthy of AAA and who wasn't, the system would be cleared and trust restored. Creative destruction can't be dismissed as a failure if it was never actually tried, and I don't think the crises is nearly as bad as the Fed would have us believe.

Accrued Interest said...


I hear you, and if I weren't sitting here on the front lines, I'd probably agree with you. It sounds like philosophically we think similarly.

But I can tell you that real live bond buyers aren't eschewing everything that isn't government backed. Right now there is a rush to corporate bonds. Today MCD brought a new issue and it was 6-times over subscribed. AMGN was 10-times.

People want to make money. The government hasn't backed enough paper to overwhelm the giant amounts of cash sitting on the sidelines.